The best definition of Interest rate risk (IRR) is the likely impact on an institution’s earnings and net asset values of changes in interest rates. It does arise when the interest rate on an institution’s principal and interest cash flows plus including final maturities, both on- and off-balance sheet, have mismatched repricing dates (Bank of Jamaica, 2005, p. 1). It has been pointed out that, “the amount of risk is a function of the magnitude and direction of interest rate changes and the size and maturity structure of the mismatch position” ((International Banking, n.d., p. 1). This essay looks at interest rate management in international banking and how it is wisely managed.
According to the international Basel Committee on banking and supervision revision of 2003, interest rate risk can be roughly decomposed into 4 categories: “repricing risk, yield curve risk, basis risk and optionality” (San Francisco, 2010, p. 1). Repricing risk being the fluctuations in interest rate levels that have different impacts on a bank’s assets and liabilities, then the yield curve risk refers to changes in portfolio values caused by anticipated shifts “in the slope and shape of the yield curve” (San Francisco, 2010, p. 1). Basis risk refers to the imperfect correlation between index rates across different interest rate markets for similar maturities and lastly optionality is “the risk arising from interest rate options embedded in bank assets, liabilities and off the balance sheet positions” (San Francisco, 2010, p. 1).
Interest rate risk in banks is where a gap risk arises out of the adverse movement of interest rates a bank faces on its currency swaps/forwards contracts or other interest rate derivatives. Interest rates in the bank are split into two: traded risk rate and non traded interest risk rate. The interest rate in the bank book arises from a bank’s core activities (Europe, 2006, p. 4)
International banking involves banking transactions crossing national borderlines and involves claims of foreign bank offices on residents, claims of domestic bank offices on domestic residents in foreign currency, all claims of domestic banks offices on foreign residents, and claims of foreign bank offices on residents. International banking also includes Eurocurrency deposits placed with banks outside the country whose currencies are denominated though not a must they be Euros (Banking, 2010, pp 1-10).
The main problem with international banking is that it is not regulated unlike banking in a country’s borders, what banks do is that they set their own guidelines on interest rate management which are mostly related to the Basel committee 1997 interest rate risk management principles and guidelines (Banking, 2010, p. 10).
Features of international banking include competition for bank loans from the international bond market, competition for market share among banks, currency risk, and complexity of credit risk are other features (Libf, 2007, p. 1).
Sources of Interest Rate Risk (IRR)
The first one is repricing risk which arises as a result of timing differences in the maturity for a fixed rate and repricing for a floating rate of bank assets and liabilities plus off the balance sheet positions). The second source of interest rate risk is yield curve risk which comes about as a result of “repricing mismatches to changes in slope and shape of yield curve” (San Francisco, 2010, p. 1. A yield curve arises when the curve makes experiences unanticipated changes which in turn put the financial position of a bank at risk of making huge losses (San Francisco, 2010, p. 1).
The third Interest Rate Risk source of risk is the basis risk that affects bank and it arises from “imperfect correlation in the adjustment of rates earned and paid on different financial instruments which have the same repricing characteristics positions” (San Francisco, 2010, p. 1).
The fourth type of source of IRR is optionality where some assets and liabilities have no contractual maturity or allow customers some option regarding maturity. Some assets and liabilities have administered rates where dates and amount or repricing are at the bank’s discretion. Another case for optionality is that banks suffer from the options embedded in many bank assets, liabilities and other balance sheet portfolios. It has been shown that lack of proper management can lead to “the asymmetrical payoff qualities of instruments with optional features can pose significant risk particularly to the seller of the option as options held are generally exercised to the advantage of the holder and to the disadvantage of the seller positions” (San Francisco, 2010, p. 1).
Some of the traditional measures taken to manage risk include country-wise limits, a turnover limit on daily transaction value for all currencies, limits on overnight positions in each currency lower than intra-day and limits on the intra-day open position in each currency (Bis, 2009, p. 1).
This is an international committee that assists financial institutions on issues touching on financial management especially those which can be considered as “key supervisory issues” (Bis, 2009, p. 1). This is accomplished by “exchanging information on national supervisory issues, approaches and techniques to promote understanding” (Bis, 2009, p. 1). The committee provides forums for members and member countries are drawn from the world’s most advanced nations and includes nations such as Brazil, USA, France, Canada, Japan, Spain, Turkey, China, Germany, Singapore, and South Korea among other nations. The committee has come up with a guideline on the principles of effective risk management that provide a framework used by many banks worldwide in the management of risk (Bis, 2009, p. 1).
Interest rate Risk Management
Interest rate management is to reduce the probable loss which may occur due to risk as much as possible. Some risk management products include forwards which is the most basic interest rate management tool, the other risk management tool is a future where a futures contract is used and is similar to a forward but provides the counterparties with less risk than a forward contract mainly leasing of default and liquefy risk. Another risk management tool is the swap; an interest rate swap is an arrangement between the counterparties to exchange sets of future cash flows. Another risk management tool is the options where options contracts are used in protecting parties involved in a floating rate loan. Collars can also be used in interest risk rate risk management where collaring is accomplished by simultaneously buying a cap and selling a floor or the vice versa (Simon, 2010, p. 1).
Some of the risk management practices or principles of interest rate management applied mostly in the world and in countries under the Basel Committee on banking and supervision include: “appropriate board and senior management oversight, appropriate risk management policies and procedures, comprehensive internal controls and independent audits and appropriate risk measurement, monitoring and control functions” (San Francisco, 2010, p. 1).
Banks all over the world tend to have a bank board of directors that ensures that the IRR is managed wisely. They also make sure that Risk managers within the IRR management system in most international banks are independent of risk-taking functions of the bank to avoid potential conflict of interest, also senior management must always ensure that “a bank’s IRR policies and procedures are clearly defined and are consistent with the nature and complexity of the bank’s activities” (San Francisco, 2010, p. 1). Most international banks tend to capture all material IRR exposures whether in their trading or banking books, within their management system: “operating limits and related practices for keeping IRR exposures within levels consistent with internal policies must be established” (San Francisco, 2010, p. 1). Stress testing is done regularly mostly in American banks and European banks (San Francisco, 2010, p. 1).
Some risk management measurement techniques are “used for derivatives and other instruments with especially risk profiles, such as mortgage backed securities” (San Francisco, 2010, p. 1).
Some of the methods used in measuring economic are duration gap and simulation. When one is measuring earnings, one uses dollar gap or maturity gap or static simulation: these techniques have been singled out for the provision of “consistent framework for analyzing a wide variety of possible interest rate scenarios positions” (San Francisco, 2010, p. 1).
However, most banking institutions have developed and implemented effective and comprehensive procedures and information systems to manage and control interest rate risk by their interest rate risk policies. These procedures are appropriate to the size and complexity of the institution’s interest rate risk-taking activities as outlined in The Basel committee on interest risk rate management positions (San Francisco, 2010, p. 1).
All over the world, banks put into use different financial tools to assist in the management of the IRR. At times it has been noted that a combination of tools can be put into use:
Most banks all over the world are known to use two approaches when accessing aggregate IRR exposures across various business lines and portfolios which are the traditional earnings approach and the new but challenging economic value approach. The earnings approach tends to focus on how interest rates changes affect a bank’s overall earnings which are measured as net income. Some of the broader measures include non-interest income such as revenue and mortgage services. This approach mostly focuses on earnings sensitivity to interest rate fluctuations of different prizes positions. In the economic value approach, it takes a wider perspective on IRR management by focusing on how interest rate changes affect total expected cash flows from all bank operations (San Francisco, 2010, p 1).
Also, the economic value approach has been defined as thus: “the expected cash flows from assets minus expected payments on liabilities plus the expected net cash flows from off balance sheet positions” (Ephilipdavis, 2010, p. 1).
Most banks in the world whether in the Basel committee or not, tend to mostly apply the Basel committee regulations on interest rate risk management guidelines as the Basel committee provides a forum for these countries to meet and discuss banking issues in their countries.
Bank of Jamaica. (2005) The Bank of Jamaica. Web.
Bis. (2009) Strengthening the resilience of the banking sector – consultative. Web.
Ephilipdavis. (2010) International banking explains inter banking. Web.
Europe. (2006) Explains technical aspects of the management of interest rate risk arising. Web.
International Banking. (n.d.) International banking. Web.
Libf. (2007) Explains International Banking. Web.
San Francisco. (2010) Supervising Interest Rate Risk Management – Federal Reserve Bank. Web.
Simon, A. (2010) Articles on swaps, options By Helen Simon, CFP. Web.