Introduction
Before the Second World War, banks experienced a stable interest rate environment (Sharifi, Saeidi & Saeidi, 2014). However, post-war, global market events led to the volatile interest rates courtesy of changes in the character of bank liabilities. The latest historically low-interest-rate environment and unfavorable economic circumstances have posed profound interest rate uncertainty to these financial institutions (Iorio, Faff & Sander, 2013). As such, many banks have endured low earnings because of substantial loan losses due to global economic crunches and a steep reduction in the worth of securities portfolios (Liao, 2013).
Besides, the range between lending and borrowing rates has narrowed for many financial institutions, a scenario that has led to a decline in lending profitability (Liao, 2013). Thus, the level and unpredictability of interest rates and the increase in worldwide financial integration have made the measurement and management of interest rate risk (IRR) one of the pivotal issues that financial institutions’ managers have to deliberate on (Sharifi et al., 2014). The present paper aims to evaluate the contemporary issues surrounding IRR by investigating the sources and causes of IRR, examining the effect of the IRR on financial institutions (FIs), and describing how financial organizations measure and manage IRR. Concerning the measurement and management of IRR, the paper discusses the use of traditional GAP analysis and derivatives as methods of control and compares their merits and demerits.
Background Information
Banks are a link between moneylenders and borrowers. They often handle client funds that bear varying maturities, a situation that is likely to adjust the position of the financial books to an interest rate sensitive point (Beets, 2004). IRR results from assets and liabilities maturing at different times and is the risk a financial institution incurs when the maturities of its assets and obligations are mismatched, and interest rates are volatile (Sharifi et al., 2014).
Banks could face interest rate risks due to variation in the margin between the amounts earned on assets and that paid on liabilities with time. Also, it could be due to the prospect of assets and liabilities to reprise at different points in time, and the period taken for those mismatches in assets, liabilities, and derivatives to persist (Sharifi et al., 2014). The survival and even success of a financial institution are dependent upon the successful management of risks; interest rate risk is one of them. As an intermediary institution, the bank has to accept and manage IRR.
Sources/Causes of IRR
Credit institutions are susceptible to changes in interest rates since those variations have a strong influence on their profitability and assets (Harris, Wu &Yang, 2015). Interest rate risks emanate from several settings. First, the typical business framework of banks or the financial industry is a source of IRR. Borrowers are frequently attracted to loans with prolonged interest rate lock-ins while the lenders favor accessing their funds at shorter notice (Bundesbank, 2012). Consequently, financial institutions convert short-term deposits into long-term loans (Bundesbank, 2012).
The situation results in mismatched maturities of bank assets and liabilities leading to reprising or reinvested risk. Second, reprising mismatches can also translate into yield curve risk. This risk occurs when there are fortuitous shifts of the yield curve that undesirably affect the firm’s income or principal economic value (Bank for International Settlements, 2004). About the duration of investment, long-term interest rate lock-ins have varied effects on the financial institution’s credit risk (Bundesbank, 2012).
On the one hand, it helps to maintain the stability of the banking system. However, if the interest rate lock-ins on loans are higher than that on deposits, it means that banks have to convert the interest rate escalations into risks for themselves (Bundesbank, 2012). Thirdly, the institution’s economic policy can also be a source of IRR. Often, banks actively manage IRR using economic value or earnings-based methods. The former observe the outcomes of likely interest rate variations on the bank’s assets while the latter focuses majorly on the impacts of its earnings under commercial law (Bundesbank, 2012).
A firm can virtually eliminate IRR in its banking book by employing interest rate derivatives, for example, interest rate swaps, that transfer IRR to the capital market (Bundesbank, 2012). Nonetheless, these derivatives can also be exploited to boost or build up IRR to make speculative earnings. This way, they become an additional probable source of IRR on the balance sheet.
Fourthly, financial market integration may give rise to basis risk when there is a limited association of bases, such as the London Interbank Offered Rate (LIBOR) and the US Treasury Bill, on which the value of returns on assets and costs on liabilities are attached (Sharifi et al., 2014). In this scenario, since bank’s assets and liabilities depend on different bases, the bank is likely to suffer unprecedented alterations in incomes and expenses if there is a move on each base in opposite directions (Sharifi et al., 2014).
Lastly, another source of IRR arises from the options entrenched in many bank assets, liabilities, and off-balance-sheet (OBS) portfolios (Bank for International Settlements, 2004). Examples of instruments with rooted options include bonds, notes with the call or put provisions, and several kinds of non-maturity securities in which the investor is entitled to withdraw money any time without any penalties (Bank for International Settlements, 2004). Since the options held, whether optional or exclusive, are often exercised to the advantage of the holder and not the seller, trading in those instruments can present a substantial risk to a financial institution (Bank for International Settlements, 2004).
Effects of IRR on Financial Institutions
The interest rate risk has two dimensions. The earning prospective defines IRR by the net interest income or the effect of interest rate movement (Liao, 2013). The second is the economic standpoint that is determined by the impact of interest rate turnover on the worth of equity (Liao, 2013). Regrettably, these risks cannot be avoided and are uncontrollable; they affect the most critical source of revenue and change the market value of a bank’s assets and liabilities. From the earning stance, variations in income are an essential fundamental area of IRR assessment since reduced earnings or total losses can threaten the financial stability of a bank by lowering its market confidence and undermining its capital adequacy (Muhamet & Arbana, 2016).
While making assessments based on the effects of the IRR on gains, various components of revenues, e.g., net interest income, non- interest incomes, and expenses are put into consideration (Muhamet & Arbana, 2016). From the economic value perspective, fluctuations in the IRR alter the value of a bank’s resources, liabilities, and OBS positions (Bank for International Settlements, 2004). Therefore, the sensitivity of a financial institution’s economic value to changes in the interest rate is a vital concern for managers, supervisors, and shareholders. The economic value of a bank represents an analysis of the current value of its projected net cash flows, discounted to echo market rates (Bank for International Settlements, 2004). This approach factors in the potential impact of interest rate changes on the current worth of all future cash flows and provides a more detailed view of the probable long-term effects of variations in interest rates (Kamau, Inanga & Rwegasira, 2015).
Embarking on the effects of IRR on banks, another area that these institutions have to deliberate on while assessing the level of IRR that they can assume is the effects that previous interest rates may bear on future performance. Some of these instruments may harbor embedded gains or losses courtesy of the past rate volatilities (Bank for International Settlements, 2004). These gains or losses may have a prolonged influence on the FI’s earnings.
Measuring and Managing IRR
The banking sector is a risky business segment in the global economy as it deals with money. Risk-taking is an ordinary business principle of banking. However, risks can be a source of threat to the profitability and survival of financial institutions. Therefore, maintaining interest rates at a prudent level is imperative to ensure the safety and soundness of financial institutions (Shen & Hartarska, 2013). IRR management refers to a collection of policies and procedures instituted by banks with “the purpose of identifying, measuring and monitoring the movement of interest rate to restrain and avoid the unfavorable risk’s impacts” (Sharifi et al., 2014, p. 3063).
Sound IRR control involves the application of proper board and senior management supervision, satisfactory risk management guidelines, accurate risk quantification, scrutiny and control functions, and extensive internal inspections and independent audits in the management of assets, liabilities, and OBS instruments (Bundesbank, 2012).
It is necessary for banks to have IRR measurement systems that analyze the impacts of rate changes on both earnings and economic worth (Bundesbank, 2012). The methods employed should provide not only relevant measures of an FI’s present level of IRR exposure but also be able to forecast any extreme exposures likely to arise (Hollis, 2014). Presently, many banks estimate their exposure to IRR internally by the use of advanced models which reflect how changes in interest rate influence “their net interest margin, return on assets and market value of assets, liabilities and equity capital.” (Handorf, 2016, p. 275). These models offer the financial institutions’ management, directors, and regulatory authorities with the necessary measurements to assess reprising risk and options exposure. Such metrics include effective duration, convexity, and value-at-risk (Handorf, 2016).
Traditionally, banks have been using gap analysis, duration analysis, simulation analysis, or scenario analysis to measure and manage IRR (Beets, 2004). Gap analysis is a fixed measure of risk that is often linked to net interest income targeting (Beets, 2004). To facilitate the calculation of the maturity gap, clustering of the assets and obligations according to their reprising intervals is necessary. Within each cluster, the gap is then expressed as the pound amount of assets less those of liabilities, i.e., GAPt = RSAt – RSLt.
Gap analysis helps to predict how a bank’s condition is likely to respond if interest rates change (Beets, 2004). Thus, it enables the predictor to obtain a quick and straightforward outlook of the summary of exposure. The downfall of this criteria is that it does not provide a single summary figure that conveys the financial institution’s IRR (Makkar, & Singh, 2013). Also, it overlooks other vital elements, e.g., cash flows, uneven interest rates on assets and liabilities, and the initial capital (Beets, 2004).
Advances in the financial theory, embrace of computer technology, and changes in Fx markets, credit, and capital markets have enabled supplementation of traditional methods of measuring and managing IRR with the more recent ones (Mouna & Anis, 2013). These new ways use derivatives. A derivative refers to a security whose value is determined by or obtained from one or more underlying assets –the notional principal amounts (Allen, Kim & Zitzler, 2013). It is a contract involving two or more parties where the value is dependent upon fluctuations in the underlying asset (Allen et al., 2013). Derivatives are often employed as tools to hedge various risks, lower funding cost, hedge debt and variations in foreign currency exchange rates, manage the balance sheet, diversify sources of funding, and for speculative purposes (Beets, 2004). They include futures contracts, forwards contracts, options, and swaps (Allen et al., 2013). Studies of firms that employ these tools have established that these institutions usually have increased value, reduced taxes, lower interest coverage, more growth prospects, and tighter financial constraints (Hollis, 2014).
Derivatives are advantageous since they enable banks to insure against risks that were previously unavoidable, and they provide a mechanism for these institutions to modify their IRR exposure (Beets, 2004). Similarly, banks can separate IRR management from their other commercial roles. Managing IRR through derivatives minimizes the need to hold high capital since derivatives enable banks to replace the significant capital requirement with inexpensive risk management.
Derivatives promote more financial intermediation since banks that use them can readily intensify their business lending. When derivatives are part of a balance sheet or portfolio, they usually have strong risk-reducing characteristics at the portfolio level (Sharifi et al., 2014). Lastly, derivatives can boost profits, lower volatility, enhance bank safety and soundness, and elicit a more efficient allocation of financial risks if they are appropriately used (Beets, 2004). Unfortunately, the use of derivatives has some downsides, as they are a potential source of financial risk exposure, do not portray the overall riskiness of a bank to the outside stakeholders, and are complicated and expensive to initiate their usage (Beets, 2004). A fixed financial cost is attached to the initial learning to use derivatives, a price that smaller banks may not be ready to incur.
Conclusion
This paper has evaluated the need for careful measurement and management of IRR and concurs that elements such as the level and unpredictability of interest rates, and the global financial services integration make the practice mandatory to ensure the survival and success of financial institutions. Banks operate under diverse economic factors in different countries, and thus the methods used to control IRR vary. However, since IRR management is a crucial issue, every bank establishes efficient strategies and processes aimed at reducing the harmful effects of IRR and maximize the gains and organizational value.
References
Allen, S., Kim, S., & Zitzler, M. (2013). Hedging instrument in post liquidity crisis: a case of interest rate swaps. Managerial Finance, 39(1), 47-59. Web.
Bank for International Settlements. 2004. Principles for the Management and Supervision of Interest Rate Risk. Basel Committee on Banking Supervision, 1-40. Web.
Beets, S. (2004). The use of derivatives to manage interest rate risk in commercial banks. Investment Management and Financial Innovations, 2(2), 60-74.
Handorf, W. C. (2016). CAMEL to CAMELS: The risk of sensitivity. Journal of Banking Regulation, 17(4), 273–287. Web.
Harris, G. R., Wu, T. L., & Yang, J. (2015). The relationship between counterparty default and interest rate volatility and its impact on the credit risk of interest rate derivatives. Journal of Credit Risk, 11(1), 93–127.
Hollis, E. (2014). Managing risk with derivatives. Credit Union Magazine, 80(5), 34-37.
Iorio, A. D., Faff, R., & Sander, H. (2013). An investigation of the interest rate risk and exchange rate risk of the European financial sector: euro zone versus non-euro zone countries. Accounting and Management Information Systems, 12(2), 319–344.
Kamau, P. O., Inanga, E. L., & Rwegasira, K. (2015). The usage of currency derivatives in multilateral banks. Management Research Review, 38(5), 482- 504. Web.
Liao, Q. (2013). An empirical examination of interest rate risk disclosure and management in bank holding companies. Web.
Makkar, A., & Singh, S. (2013). Interest rate risk of selected Indian commercial banks: An application of GAP analysis model. The IUP Journal of Bank Management, 12(4), 58-69.
Mouna, A., & Anis, M. J. (2013). The impact of interest rate and exchange rate volatility on bank’s returns and volatility: evidence from Tunisian. International Journal of Information, Business and Management, 5(4), 73-90.
Muhamet, A., & Arbana, S. (2016). The effect of credit risk management on banks’ profitability in Kosovo. European Journal of Economic Studies, 18(4), 492- 515. Web.
Sharifi, O., Saeidi, M., & Saeidi, H. (2014). Interest rate risk management using income and duration gap analysis in banks- an empirical study. MAGNT Research Report, 2(7), 3058-3071. Web.
Shen, X., & Hartarska, V. (2013). Derivatives as risk management and performance of agricultural banks. Agricultural Finance Review, 73(2), 290-309. Web.
Bundesbank. (2012). The role of the “Basel interest rate shock” in the supervisory assessment of interest rate risks in the banking book. Monthly Report of the Deutsche Bundesbank, 64(6), 51-60.