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Interest Rate Risk

Management in Banks



1 Acknowledgement
2 Introduction
3 Literary Review
4 Interest Rate Risk Management Methods
Maturity Gap Method

Rate adjusted gap method

5 Analysis

6 References

I would sincerely like to thank Prof. Vigneshwar Swamy for giving me the opportunity to
work on the project-“Interest Rate Risk Management in Banks” under his able
guidance. He has been instrumental in guiding me from time to time, throughout the
project by squeezing out time from his hectic schedule.

In all it was a wonderful learning experience which helped me in gaining useful insights
about the subject, Risk Management in Banks, particularly on the topic given. Lastly I
would like to thank my friends for their everlasting support and help.

Risk is the sole cause of the creation of many problems. This has led to the birth of
various instruments and techniques to hedge or control the risk. With the developments of
financial markets and economies of the world, risk and its management has gained more
importance over the years. This is more so in case of the banking sector. Risk is an
inherent part of business model of bank and an efficient risk management is vital for the
success of bank. Banks are usually faced with many kinds of risks namely credit risk,
operational risk, liquidity risk, interest rate risk etc. Interest rate risk is the largest market
risk in banks. The variable, to which the assets and liabilities of the bank are most
sensitive, is the interest rate and the technique of managing the same is known is Interest
Rate Risk Management. There are various methods of interest rate risk management –
maturity gap method, rate adjusted, duration analysis, hedging, sensitivity analysis,
simulation and game theory.

In this project we will be looking at two methods to manage interest rate risk namely:

• Maturity gap method

• Rate adjusted gap method

Interest rate risk or market risk is the potential impact on the net interest income and
net assets due to the change in the interest rates. The amount of risk depends upon the
direction and magnitude of interest rate change as well as on the size and maturity
structure of the mismatch position. Interest rate risk management is the technique
whereby the assets and liabilities of the banks are managed in such a way that the risk
arising out of interest rate fluctuations has no or minimal adverse impact on the net
interest income of the bank.

After the liberalization, privatization and globalization in India in 1991, the problem of
interest rate risk has increased manifold. This is due to the deregulation of interest rate
by Reserve Bank of India (RBI).

Interest rate risk may arise under the following conditions:

• Assets and Liabilities have floating rate of interest.

• Monetary authority regulations.
• Re-pricing when assets/ liabilities approach maturity.

The interest risk can be segregated into the following:

• Rate level risk: This arises either due to market conditions or due to regulatory
• Volatility risk: This arises due to short term fluctuation usually experienced in
call money markets.
• Prepayment risk: This arises due to mismatch of the interest rates due to
prepayment of loans.
• Call/ Put Risk: Risk arising due to inbuilt call and put options in bonds and
• Reinvestment Risk: The risk arising as a result of reinvestment of the payments
of interest, installments etc of the loans.
• Basis Risk: The risk arising due to assets and liabilities being linked to different
benchmarks. These benchmarks may not move at the same rate, hence resulting in
basis risk.
• Real Interest Rate Risk: Risk arising due to inflation factor. As the change in
nominal interest rates may not match with change in inflation rate.
Taking into consideration the above elements of interest rate risk, the methods for the
interest rate risk management techniques would hereby be examined in context of ICICI
and HDFC bank.

Literary Review
One of the major financial sector reforms of 1991 was the deregulation of interest rates.
This led to the banks being exposed to the volatility in interest rates and subsequent
interest rate risks. Thus arose the need for interest rate risk management. The table below
shows the instruments introduced post liberalization.

Time line

Year Institution Action taken/Instruments

1991 GOI Financial sector reforms – deregulation of interest rates
1999 RBI Hedging instruments like interest rate swaps(IRS), over the counter interest rate
derivatives, forward rate agreements
2003 NSE Exchange traded interest rate futures contract(IRF)

While the IRS were a huge success the IRF failed.

• Working group on interest rate futures: The RBI’s working group on interest
rate futures (February 2008) observed that “banks, primary dealers, insurance
companies and provident funds who between them carry almost 88% interest rate
risk an account of exposure to GOI securities, need a credible institution
hedging mechanism to serve as a “true hedge” for their colossal pure-time-value-
of-money/ credit-risk-free-interest-rate-exposure”.1 Thus they are again started
looking at interest rate futures by appointing a working committee on it.

• According to the Centre for study of African Economies (Naude 1995) interest
rate deregulation not only leads to interest rate risk, but furthermore the interest
rate risk management may itself lead to reduction in credit supply.2 Hence even
its usefulness as projected by the Basel committee for capital adequacy is in
doubt. Another critical aspect stated is that it causes volatility in bank earnings
due to possibility of cycles in interest rate and the economic conditions. This can
be further validated by the current global economic financial crisis which is
seeing a lot of fluctuations in interest rate.

• Bob Collie (2009) in his article “Which way to go - Plotting the future course of
liability driven interest” states that majorly the market conditions drive change
and there can be four steps to interest rate risk management. These are lengthen,
reallocate, overlay, immunize. He further talks about natural hedging techniques
like netting the position by realigning the asset portfolio such that it responds to
interest rates in the same manner as liabilities do. He also advocates changing the
benchmark of fixed income portfolio’s from an aggregate, broad market fixed
income index to an equivalent long-duration index. Overlaying, i.e. using
derivative instruments like swaps will help. Traditionally the use of duration and
convexity of cash flows was used as the main measure of risk in interest rate risk
management. More recent approaches to interest rate risk incorporate a stochastic
approach to model interest rates.

• Alpa Dhanani of Cardiff University UK, Suzzane Fifield, Christine Helliar and
Lorna Stevenson of School of Accounting and Finance UK (2007), in their
research paper, analyzed, as to why UK companies hedge against interest rate
risk. Their finding were that they do so due to five basic theories namely tax and
regulatory arbitrage, under-investment, volatility of earnings and future
planning, financial distress, managerial self interest and economies of scale.

• A study on 50 banks ( both public and private sector) in India using the maturity
gap method conducted in 2003 revealed that only 8 out of the 50 banks were
adequately hedged to interest rate movements in either directions. 15 out of 50
were in safe zone if interest rate rises. Whereas 30 of the 50 banks would be safe
in interest rate falls.

Interest Rate Risk Management Methods

I. Maturity Gap Methods

The maturity gap method focuses on the gap between the risk sensitive assets (RSA’s)
and risk sensitive liabilities (RSL’s) as per their maturity periods. An asset or liability
can be said to be risk sensitive if it is affected by the change in interest rates during re-
pricing, regulations by the RBI, cash flow during the time interval taken, it is pre-payable

The RSA and RSL’s can be classified into maturity buckets ranging from 1 day to 5 years
and above. This maturity refers to the first possible reprising due to change in interest
rates. Thus these maturity buckets are also known as time buckets. The commercial
banks, as per RBI guidelines are supposed to maintain their cash inflows (assets) and
outflows (liabilities) in different residual maturity periods or time buckets. The residual
maturity is the remaining period to their maturity. These assets and liabilities are divided
into 8 time buckets. They are 1-14 days, 15-28 days, 29-90 days, 91-180 days, 181-365
days, 1 to 3 years, 3 to 5 years, and above 5 years.

Based on this the gap is then calculated as the difference between the RSA’s and the
RSL’s. In order to do so, each bucket of asset is matched to each bucket of liability and
the mismatch between the two is the gap. Further the cumulative gap is found out.

Thus, Risk sensitive Gap (RSG) = RSA’s-RSL’s.

This gap may be positive or negative. Positive gap means RSA’s > RSL’s and negative
gap means RSL’s > RSA’s. If it is a positive gap then there will be positive correlation
between the change in interest rate and the net interest income (NII). And if there is a
negative gap then there will be a negative correlation between the change in interest
rate and the NII. Thus the banks manage their interest rate risk by maintaining a positive
gap if they expect the interest rates to rise in future and similarly they maintain a
negative risk if they expect the interest rates to fall in future. In other words we can say
that the gap report indicates if the bank is in a position to benefit from rising interest rates
by maintaining positive gap or benefit from declining interest rates by maintaining
negative gap.

Thus the basic objective of this model is to stabilize or improve the net interest income
during short run over the gap periods. However this model has certain limitations:

o Firstly it is based on an assumption that there is an equal change for

interest rates in all assets and liabilities.
o The success of the gap analysis depends on the bank’s ability to forecast
the interest rates.
o The model does not take into consideration the time value of money for
the cash flows during the gap period.

II. Rate Adjusted Gap Method

Similar to the maturity gap method is the rate adjusted method, but it does away with the
assumption that there is an equal change in interest rates for all assets and liabilities.
Hence, this method allots weights to different asset and liability classes based on the
estimated change in the rate for these assets/ liabilities for a given change in interest rate.
Therefore rate adjusted gap equals (RAG) to:

RAG= [RSA1*WA1+RSA2*WA2+………..] - [RSL1*WL1+RSL2*WL2+…..]


WA1, WA2 = Weights of the corresponding RSA’s

WL1, WL2 = Weights of the corresponding RSL’s


ICICI is India’s second largest bank and the largest private sector bank with total assets
of Rs. 3674.19 billion as of June 30, 2009. ICICI’s goal’s in risk management is to
understand measure and monitor the various risks and strictly adhere to the policies and
procedure established to address these risks.

Movements in domestic interest are the main source of interest rate risk for the ICICI
bank because their balance sheet predominantly consists of rupee assets and liabilities.
The entire interest rate risk management is monitored by the asset-liability committee
(ALCO). The limits set of interest rate risks are monitored and reported to ALCO on a
periodic basis.

Some key elements of ICICI bank’s interest rate risk management policies.
• Domestic deposit taking is usually at fixed rate of interest for fixed periods except
for savings and current deposits.
• In contrast to the above a large part of foreign currency loans are at floating rates.
• Housing loans are at floating rates and interest rate for the same are reset every
• The bank tries to minimize interest rate risk on undisbursed commitments by
fixing interest rates on rupee loans at the time of loan disbursements.
• The bank also uses the duration of government securities portfolio as a variable
for interest rate risk management, where the duration of this portfolio is increased
or decreased to simultaneously increase or decrease the interest rate risk exposure.
• They are an active participant in the interest rate swap market.3

In the conference call on FY2009 results of ICICI bank, Ms. Chanda Kochar, the
bank’s Chief commented that the environment this year has been very volatile. She said it
was a year of unprecedented volatility and the interest rate movements have been quite

• Maturity gap method

Using the maturity gap method for ICICI bank for the year 2009, we see that the bank has
maintained a positive gap of 43464.3 million rupees. Since the gap is positive we can
conclude that RSA’s>RSL’s. Further a positive gap also means that the bank is predicting
a rise in the interest rates as that would lead to an increase in their NII. ICICI reported an
NII of 83.67 billion in FY09 as compared 73 bn. in the previous year. The report
considers what would be the effect on the bank’s NII when the Interest rates change by
1% (both upward and downward). The current interest rate is 8.45%, upon increasing it
by 1% to 9.45%, the corresponding NII becomes 84.13 bn., which is in increase over the
actual value. This proves that by maintaining a positive gap ICICI can take the advantage
of increase in interest rates. Similarly if the interest rate falls to 7.45%, the NII value will
decrease to 83.26 bn. Thus if the forecasting of the ICICI bank’s treasury department
goes wrong and the interest rates fall, then the bank will have to suffer a decrease in its
NII. NIM of the bank grew to 2.4% from the previous year.

We know that NII = Earning assets *NIM

Change in NII = Earning assets * NIM * acceptable change in NIM………….


Every bank first decides on what amount of risk it is willing to bear, in other words to
what is the extent to which it will be safe. It decides upon the maximum and minimum
levels for the NIM. In its ALM technique, the bank can take various risk exposure levels
and still remain within the acceptable limits of NIM. The acceptable change in NIM is
thus a policy decision (decided by top management) of the bank regarding what variation
in NIM is acceptable or tolerable by it.
We also know that Change in NII = gap * change in interest rates.

Thus from equation 1, we get

Earning assets * NIM * acceptable change in NIM = gap * change in interest


Since we know all the value of all the above figures, it was found that the acceptable
change in NIM for ICICI bank is 0.47%. This means the bank is quite risk averse and
the variation in NIM acceptable to it is only about 0.5%

• Rate Adjusted Method

In this method, the probable change interest rates for individual assets and liabilities are
determined by studying the current economic environment and looking at the trend of
past rates over the last 2-3 years. This change in interest rates is called as weights.. Using
these weights the risk adjusted gap of ICICI comes out to be 255093.8 million rupees.
Again as corresponding to the maturity gap method, the gap is positive, which would be
beneficial in case of increasing interest rates.

Predicting the interest rates and weights for rate adjusted gap method (for both
ICICI and HDFC) ………………………………….(I)

Predicting the interest rates in the current scenario is not an easy task as India is
experiencing the effects of global economic recession. The policy makers themselves are
facing a dilemma in fixing the interest rates. This is because while the monetary policy
tries to lower rates at the time of slowdown, the fiscal policy on the other hand points to
higher interest rates due to high fiscal deficit. According to an economic research by Mr.
Amol Agarwal (July, 2009), there are four main interest rate indicators.5 10 yr G-secs are
one of the indicators of interest rates as they are the most liquid security and form the
bulk of intra-day trading. The second indicator is the lending rates of commercial banks
i.e. the prime lending rates of top five banks in a month. Third we consider the corporate
spreads across different tenors which give us a fair idea about the risk levels in corporate
bond market. The fourth indicator is NSE overnight Mibor which gives an idea about
movement in money markets.

Thus expecting the fiscal policy to tighten in the coming future, the project assumes a
general trend of increase in interest rates.

o Business standard reported on July 8th, 2009 that “Bankers anticipate

rising interest rates in the next six months. The overall consensus was that
the days of softer interest rates were over, since the government would be
forced to pack in a dramatic increase in borrowing in the next three
months, pressing the Reserve Bank of India to buy more bonds from the
market, crowding out borrowing by the private sector.”6
o Live mint reported on July that interest rates may harden. With enough
liquidity in the system now the rates may even increase if liquidity is not
managed well.7
o Most recently financial express reported on August 29th that major banks
including the largest state bank of India expect the interest rates to remain
stable in the next six months. S.Sridhar CMD of central bank of India said
that short term interest rates would depend on liquidity which was enough
in the system.8
• Further the interest rates and weights have been predicted looking at the trend for
the past three years.
• On the asset side, the most weightage is given to interbank and RBI funds are
they experience major fluctuations being a part of money market. The next
weightage is given to investments and least weightage is given to advances and
• On the liabilities side maximum weightage is given to borrowings and least to
deposits as they are considered relatively fixed as compared to borrowings.


HDFC bank or Housing and Development Finance Corporation, commands a major share
(around half) in the housing mortgage market lender in the country with an assets base of
Rs 186, 1150 million and Net Profit of Rs. 6061.1 millions as on June 30th, 2009.

Like any other bank, the volatility in the domestic interest rates is the major source of
interest rate risk or market risk for HDFC. The two main categories to which the bank
lends are – Retail and Wholesale. The years 2008-09 witnessed significant change in
aforementioned two segments, thanks to the global turmoil and the growing inflation in
the initial months of the year. The higher inflation led to higher interest rate which
resulted in the rise in the real estate prices. This hike in the real estate prices converted
into lower housing demand and hence lower demand for credit and raised the possibilities
of defaults from real estate companies. Though the wholesale segment forms around only
12% of the loan book, yet the possibilities of defaults cannot be ruled out in this volatile
environment. On the other hand, retail segment which accounts for two third of the total
loan book of the bank, did not feel the heat much as most of the retail portfolio comprises
of individual borrowers, who borrow funds for self occupation. As a result of which the
defaults in this segment were minimal. Following points highlight the steps taken by the
bank in order to minimize interest rate risk:

• The interest rate risk management policy of HDFC over the years has involved
the use of derivative products like interest rate swaps, currency swaps and
• It has been able to keep the NPA around 1% through strict monitoring and lower
loan-to –value (LTV) ratio (around 65%), which is the proportion of loan value to
property value), allowed to borrowers.
• Also the funds have been allocated for property development rather than for land

Below given is the brief analysis of the two methods of interest rate risk management
applied on the maturity buckets of HDFC.

• Maturity Gap Method

According to the maturity gap method, the bank has a positive gap of Rs.103328.5
millions in the year 2008-09. A positive gap is a sign depicting that bank expects it NII
to increase with the increase in the interest rates. The NII of the bank in the year grew
from Rs. 52278.8 in FY 07-08 to millions to Rs. 74211.6 in FY 08-09. The interest rates
for the bank for the year 2008-09 have been calculated to be 10.16% on inflows and
5.92% on outflows. With the uncertainty in the economy regarding the likely direction of
interest rates, the effect of 1% change in interest rate has been taken on the NII. With the
upward movement in the interest rates the NII increases to Rs. 75302.41 million and with
the corresponding reduction in interest rate by 1%, NII decreases to Rs. 73235.84 million.

Since either of the two situations can take place, it becomes necessary for the bank to
determine the level of change that is acceptable by it in its NIM with the corresponding
change in the interest rate. As given by equation 2, acceptable change in NIM for
HDFC comes out to 1.34%. This shows that the bank is more open to face adverse
conditions and can accept a deviation in its NIM up to 1% either ways.

Considering the present uncertainty surrounding the interest rates post budget and the
announcement of disinvestment plan of the government, it can be concluded that a
change of 1% is acceptable to face the situation. As the inflation in the coming months is
likely to go up and the hitherto available surplus funds in the economy are likely to dry
with IPO market reviving, the interest rate are likely to go up. Hence the bank should
prepare itself to face the increasing interest rate scenario in future.

• Rate Adjusted Method

According to the Rate adjusted method, the risk adjusted gap for the bank comes out to
be Rs. 143295.54 millions. The weights to the respective assets and liabilities have been
allotted based on the same assumptions as made for ICICI bank. The gap according to
this method also comes out to be positive and shows that there is linear relationship
between interest rate and NII. In comparison to the HDFC, ICICI bank appears to be less
flexible as the acceptable change in NIM is 1.34% in case of former and 0.477% in case
of latter.
As written above in (I) the interest rates are expected to rise or stay stable in the future at
least in the next six months. Keeping this in mind both the banks have done good for
themselves by maintaining a positive gap. Unless there is some unexpected movement in
the interest rate, the increase in interest rates will ensure an increase in the net interest
income of the banks. Even if the interest rates remain stable as given in the latest
predictions, the banks will still successfully manage to hedge the interest rate risk.

Both the banks are quite risk averse as they have low acceptable change in net interest
margin – 0.47% (ICICI) and 1.34% (HDFC).

• Mifo- Icfai publications
• Hdfc annual report 2009,2008,2007
• ICICI annual report 2009,2008,2007