Analyzing Interest Rate Risk In Banking Books – Summary And Regulatory Requirements

Interest Rate Risk

Interest rate risk is the risk of the bank of decrease in profit and equity on account of fluctuating interest rates. The sensitivity of change in price of bond to change in interest rate in the market shall impact the influence of interest rate risk. The sensitivity of the bond shall be influenced by two factors:

• The time to maturity of the bond;
• Coupon rate of the bond.

In other words, interest rate risk is the risk of change in equity value on account of change in the absolute level of interest, change in the spread of two interest rates, change in the shape of yield curve, or in other relationship. The interest rate risk can be diversified away by hedging or diversifying.

The Basel Committee on Banking Supervision has issued standard on Interest Rate Risk on Banking Book. The supervision details out supervisory expectations pertaining to identification of risk, measuring such risk, monitoring of such risk and control of it. The BASEL III announcement made enhancement to the guidelines stated in 2004 principles. The enhancements details have been stated here-in-below:

• Stricter threshold for the purpose of identification of outlier banks by reducing the initial identification of 20% of total bank assets to 15% of the tier -1 Capital.
• An updated standardised framework which can be mandated or voluntarily adopted by managers of bank;
• The disclosure requirement has been enhanced on order to provide greater comparability, consistency and transparency for the purpose of managing and measuring Interest Rate Risk on Banking Book. The same includes disclosure of quantitative figures on account of common interest rate shock scenarios;
• Extensive guidance has been provided regarding the expectation of bank management of Interest Rate Risk on Banking Book as well as development of interest rate shock scenarios. Further, it provides guidelines on the key behavioural and modelling assumptions which shall be undertaken for the purpose of measuring the risk.

In the said standard, Economic Value of Equity risk measure of Interest Rate Risk on Banking Book. Under the method, estimation is made regarding the amount by which the net present value of the cash flows that shall arise to the bank both on and off the balance sheet positions under the prevailing term structure change in interest rates under different scenarios of interest rates in future. The exposure of bank to Interest Rate Risk on Banking Book is computed by or equal to the largest negative change in Economic Value of Equity under different scenarios. In short the risk is measured by the theoretical risk that may accrue to banks equity on account of change in interest rates. (IRRBB – Pillar 2 standardised framework – Executive Summary, 2017)

Further, the framework is not fully standardised and specifies six interest rate shock scenarios for banks to use.

Further Under APRA, the same is covered under Prudential Standard APS 117 Capital Adequacy: Interest Rate Risk in the banking Books. The computation is done by analysing the sensitivity of economic value of fundamental tier-1 capital to change in the interest rates

The risk of Interest Rate Risk in Banking Books in Bendigo and Adelaide Bank arise generally on account of non-traded market risk. The risk generally is represented by potentially negative impact to NII on account of mismatch between maturity and repricing dates of its assets and liabilities which occur in the normal course of business. For the computation of exposure to risk the Economic Value of equity risk has been calculated at 100Basis points positive and negative. The detailed simulation has been presented here-in-below:

For Bendigo and Adelaide Bank

For Group
2016
Assets	Floating Interest Rate	Less than 3 Months	Between 3 and 6 months	Between 6 and 12 months	Between 1 and 5 years	After 5 years	Non Interest earning	Total Carrying value	Weighted Average Effective Interest Rate
Cash and Cash Equivalent	698.7	18	18.1	36.2	108.7		180.3	1060	1.4
Due from other financial institutions							220.8	220.8
Financial Asset held for trading		1795	2090.1		2484			6369.1	1.94
Financial Asset held for sale		322.7					0.5	323.2	2.29
Financial Asset held to maturity	25.3	268.5	89					382.8	2.86
Loans and other receivables	35648.9	8141	1313.1	2634.3	9475,7	40.6		47777.9	5.02
Derivatives							79	79
Total Financial Assets	36372.9	10545.2	3510.3	2670.5	2592.7	40.6	480.6	56212.8
Liabilities
Due to other Financial Institutions							267.4	267.4
Deposits	20415.9	20316.9	9185.1	5445.7	1689.7	1.4		57054.7	2.28
Notes Payable	519.6	3302.9						3822.5
Derivatives							111.8	111.8
Convertible Preferenece shares			824.4					824.4	4.43
Subordinated Debt		583.4						583.4	5.34
Total Financial Liabilities	20935.5	24203.2	10009.5	5445.7	1689.7	1.4	379.2	62664.2

Assets	Floating Interest Rate	Less than 3 Months	Between 3 and 6 months	Between 6 and 12 months	Between 1 and 5 years	After 5 years	Non Interest earning	Total Carrying value	Weighted Average Effective Interest Rate
Cash and Cash Equivalent	572.4	18.1	18.1	36.2	108.7		179.5	933	1.7
Due from other financial institutions							220.8	220.8
Financial Asset held for trading		1685.1	2090.1		2594.2			6369.4	2.02
Financial Asset held for sale	217.8	6699.8						6917.6	3.1
Financial Asset held to maturity		62.7						62.7	3.75
Loans and other receivables	31046.8	8031.9	1313.9	2362.6	9473.1	52.3		52280.6	4.87
Derivatives							290.3	290.3
Total Financial Assets	31837	16497.6	3422.1	2398.8	12176	52.3	690.6	67074.4
Liabilities
Due to other Financial Institutions							266.9	266.9
Deposits	18945.2	19798	8506.7	4739.8	1795.2	1.4		53786.3	2.28
Notes Payable	502.2							502.2
Loan Instrument to Securitisation Trusts	7252	143.3	171.9	327.5	1542.6			9437.3	5.02
Derivatives							110.7	110.7
Convertible Preference shares			824.4					824.4	4.43
Subordinated Debt		573.4						573.4	5.34
Total Financial Liabilities	26699.4	20514.7	9503	5067.3	3337.8	1.4	377.6	65501.2

Group	-+100 Basis Point	-100 Basis Point
Net Interest Income	34.1	-38.1
Ineffectiveness of derivatives	-33.1	33.1
Income Tax effect @30%	-0.3	1.5
Effect on Profit	0.7	-3.5
Effect on Profit	0.7	-3.5
Cash Flow Hedge Reserve	-24.2	24.2
Income Tax effect @30%	7.3	-7.3
Effect on Equity	-16.2	13.4
Bank	-+100 Basis Point	-100 Basis Point
Net Interest Income	24.9	-29.2
Ineffectiveness of derivatives	-33.1	33.1
Income Tax effect @30%	2.5	-1.2
Effect on Profit	-5.7	2.7
Effect on Profit	-5.7	2.7
Cash Flow Hedge Reserve	-23.2	23.2
Income Tax effect @30%	7	-7
Effect on Equity	-21.9	18.9

On perusal of the above, increase in interest rate shall decrease the value of equity by 16.2 Mio for Group and 21.9 Mio for company on account of loss under cash flow hedge reserves taken for the purpose of protection against downfall or interest rate risk. Further, in case the interest rate rises the group shall have profit of 13.4 Mio while the bank shall have the profit of 18.9 Mio on account of cash flow hedge reserve being fruitful.

Consolidated	As at $ Mio	High for Year $ M	Low for Year $ M	Avg for Year $M
Value at Risk at 99% Confidence interval
Australia	38.4	40.6	28	33.70
New Zealand	11.4	11.4	8.8	10
Asia Pacific, Europe and America	14.7	17.3	14.4	15.8
Diversification Benefit	-24	-24.6	-19.9	-22.9
	40.5	44.7	31.3	36.60
Company	As at $ Mio	High for Year $ M	Low for Year $ M	Avg for Year $M
Value at Risk at 99% Confidence interval
Australia	38.4	40.6	28	33.70
New Zealand	0.1	0.1	0	0.1
Asia Pacific, Europe and America	14.6	16.8	14	15.3
Diversification Benefit	-9.2	-13.6	-12.6	-13.2
Total	43.9	43.9	29.4	35.90

On perusal of the above, that at Value of Risk of 1%, the high can go up to 44.7 Mio and low up to 31.3 Mio at the group level. Similarly at the bank level the highest is at 43.9 Mio and lowest at 29.4 Mio at 1% VAR or shock of 1%.

The exposure to losses in case of Bendigo and Adelaide Bank and ANZ bank are more or less similar as  in both the cases the net impact is loss in case of Value at Risk of 1%. Further, in case of ANZ Bank tax impact has not been considered for analysis and computation has been done location wise.

Further, the results are similar on account of similar exposure and strategies adopted like cash flow hedge and interest rate contracts like forward rate agreement, Swap agreement, future agreement and options.

The companies have been trying effectively to control the risk but the exposure of the same cannot be eliminate completely and over the year in case of Bendigo and Adelaide Bank things have worsened on account of increase in business and similar for ANZ Bank.

Conclusion:

On the basis of above, it can be concluded that interest rate risk plays a crucial role in the banking sector as interest is one of the main sources of revenue of the bank and managing the same is essential for proper functioning of the bank. Further, the methodologies proposed under BASEL III regarding computation if shocks and value of equity has been tested on the basis of annual report of the companies and exposure has been computed to find out that the risk exists in the books of both banks.

References:

IRRBB – Pillar 2 standardised framework – Executive Summary. (2017, june 24). Retrieved October 22, 2018, from www.bis.org: https://www.bis.org/fsi/fsisummaries/irrbb.htm