Banking and financial system are the backbone of any economy. Assets and liabilities Management (ALM) of banks is a dynamic process of planning, organizing, co-ordinating and controlling the assets and liabilities. This includes their mixes, volumes, maturities, yields and costs in order to achieve a specified Net Interest Income (NII). The Net Interest Income is the difference between interest income and interest expenses and the basic source of bank's profitability. Banks are always aiming at maximizing profitability and at the same time trying to ensure sufficient liquidity. In case there happens to be any disorderly adjustments in the financial markets, there may be implications for the banking sector through changes in the interest rates and liquidity shifts. A sharp rise in interest rates may result in marked to market losses on the investment portfolio of banks. This concept has gained importance in Indian conditions in the wake of the ongoing financial sector reforms. This particularly refers to reforms that relate to interest rate deregulation. The technique of managing both assets and liabilities together has come into being as a strategic response of banks inflationary pressure, volatilities, in interest rates and severe recessionary trends which marked the global economy in the seventies and eighties. The major focus of prudential regulation in developing countries has traditionally been on credit risk. While banks and their supervisors have grappled with non-performing loans for several decades, interest rate risk is a relatively new problem. Administrative restrictions on interest rates in India have been steadily eased since 1993. This has led to increased interest rate volatility. Hence there is a need to measure the interest rate risk exposure of Indian banks. This paper attempts to measure the Interest Rate Risk exposure of State Bank of India (SBI), by using GAP Analysis Technique. Using publicly available information, this paper attempts to assess the interest rate risk carried by SBI in 2006, 2007 and 2008
Introduction
Banks have twin objectives of maximizing profitability and at the same time trying to ensure that there is sufficient liquidity. To achieve these objectives, it is essential that banks have to monitor, maintain and manage their assets and liabilities portfolios in a systematic manner taking into account the various risks involved in these kinds of areas. This concept has gained importance in Indian conditions in the wake of ongoing financial sector reforms, particularly reforms relating to interest rate deregulation.
The technique of managing both assets and liabilities together has come into being the strategic response of banks to inflationary pressure, volatility in interest rates and the severe recessionary trends which marked the global economy in the seventies and eighties. In case of any disorderly adjustments in the financial markets, there will be implications for banking sector through changes in interest rates and liquidity shifts. Sharp rise in interest rates may result in marked to market losses on the investment portfolio of banks. This paper aims to measure the interest rate risk exposure of one of the public sector banks viz SBI from 2005 to 2008 through Gap Analysis.
Key Policy Rates and Yield Curve
Major focus of prudential regulation in developing nations has been traditionally on credit risk. While banks and their supervisors have grappled with non - performing loans for several decades, interest rate risk is a relatively new problem. Administrative restrictions on interest rates in India have eased steadily since 1993. This has led to increased interest rate volatility. Table shows the movement in key policy rates in India during the study period. The yield curve has shifted upward in March 2004, with the 10-year yields moving from 5 to 7 per cent (Fig 1). However, the longer end of the curve has flattened. The significant drop in turnover during 2004-05 and 2005-06 could be due to a "buy and hold" tendency of the participants other than commercial banks (like insurance companies) and also due to the response of investors to the interest rate cycle. In the absence of short selling in government securities, participants generally refrained from adopting positions which resultedin volumes drying up in a falling market. The Bank's efforts to elongate the maturity profile resulted in a smooth and stable yield curve to act as a benchmark for the other markets for pricing and valuation purposes. The weighted average maturity of securities increased to 14.6 years during the period 2006-07. The weighted average yield of securities also declined to 5.7 per cent in 2003-04 and since then, it has increased to 7.9 per cent in 2006-07. The Indian yield curve compares not only with emerging market economies but also the developed ones.
The interest rate risk of major banks in India can be calculated / measured using two methodologies. The first consists of estimating the impact upon equity capital of certain interest rate shocks. It will be observed that roughly two-thirds of the banks in the sample will stand to lose or gain over 25 per cent of equity capital in the event of a 320 bps move in interest rates. The second methodology consists of measuring the elasticity of bank stock prices to fluctuations in interest rates. The stock prices of roughly one-third of the banks have significant sensitivities.
Methodology Used
This was an analytical research study. It selected State Bank of India (SBO), one of the public sector banks (first and largest) in India. SBI is also listed in BSE and NSE. The study used both primary as well as secondary data. The primary data which was required was collected from personal discussions with the staff to know the Asset Liabilities Management (ALM) practices being used in SBI. The personal discussions also yielded information regarding the problems that were faced in the course of exchanging information for the ALM management. The secondary data was collected from the annual reports and circulars of Indian Bank, reading matter on Asset Liability Management (ALM) was provided by the bankers Staff College, websites and various other journals. In this present study, Gap Analysis Technique which has been prescribed by Reserve Bank of India (RBI) has been used for the measurement of the interest rate risk.
Interest Rate Risk in Banks
The ALM system is a system of matching cash inflows and outflows. Thus it is mainly liquidity management. Balance sheet risk can be categorized into two main types of significant risks which are liquidity risk and interest rate risk. The ALM system stands on 3 pillars :
(a) ALM Information System (MIS)
(b) ALM organization (responsibilities)
(c) ALM Process (Risk parameters, identifying, measuring, managing risks and setting risk policies and tolerance levels)
Interest rate risk is the risk to earnings or capital arising from movement of interest rates. It arises from the differences between the timing of rate changes and the timing of cash (re - pricing risk); from changing rate relationships between yield curves that affect activities (basis risk); from changing rate relationships across the spectrum of securities (yield curve risk); and from interest-rate-related options embedded in products (option risk). The value of a banks' assets, liabilities and interest-related, off-balance-sheet contracts is affected by a change in rates because the present value of future cash flows, and in some cases the cash flows themselves, is affected. For measuring interest rate risk, banks use a variety of methods such as analysis, the duration gap method, the basis point value (BPV) method, and valuation methods.
Interest Rate Risk Management in SBI
Interest rate risk refers to fluctuations in Banks' Net Interest Income and the value of assets and liabilities arising from internal and external factors. Internal factors include the composition of the Bank's assets and liabilities, their quality, maturity, interest and re-prcing period of deposits, borrowings, loans and investments. External factors cover general economic conditions. Rising or falling interest rates impact a bank depending upon its balance sheet positioning. Interest rate risk is prevalent on the asset as well as the liabilities side of the Banks' balance sheet. The Asset Liability Management Committee (ALCO) which is responsible for evolving appropriate systems and procedures for ongoing identification and analysis of balance sheet risks and laying down parameters. This is for efficient management of these through the asset liability management policy of the bank.
ALCO also develops the market risk strategy by clearly articulating the acceptable levels of exposure to specific types of risk (i.e. interest rate, liquidity, etc). The Risk Management Committee of the Board of Directors (RMCB) oversees the implementation of the system for ALM and reviews its functioning periodically and provides direction. It reviews various decisions taken by the ALCO for managing market risk.
Interest rate risk exposure is measured with Interest Rate Gap Analysis, Simulation, Duration and Value-at-Risk (VAR). RBI has stipulated monitoring of interest rate risk at monthly intervals through a Statement of Interest Rate Sensitivity (Re-pricing Gaps) to be prepared as the last Reporting Friday of each month. Accordingly, ALCO reviews Interest Rate Sensitivity statement on a monthly basis. Interest rate risk in the Fixed Income portfolio of the bank's investments is managed through Duration Analysis. Bank also carries out Duration Gap Analysis (on quarterly basis) to estimate the impact of change in interest rates on economic value of Bank's assets and liabilities and thus arrive at changes in Market Value of Equity (MVE). The prudential limit aims to restrict the overall adverse impact on account of market risk to the extent of 20 per cent of capital and reserves, while part of the remaining capital and reserves serves as a cushion for credit and operational risk. The impact of interest rate changes on the Market Value of Equity is monitored through Duration Gap analysis by recognising the changes in the value of assets and liabilities by a given change in the market interest rate. The change in value of equity (including reserves) with 1 per cent parallel shift in interest rates for both assets and liabilities needs to be estimated. Maximum limit up to which the value of the equity (including reserves) will get affected with 1 per cent change in interest rates is to be restricted to 20 per cent of capital and reserves.
Gap Analysis Technique
Gap analysis is a technique of asset - liability management that can be used to assess interest rate risk or liquidity risk. It measures at a given date the gaps between Rate Sensitive Liabilities (RSL) and Rate Sensitive Assets (RSA) (including off - balance sheet positions) by grouping them into time buckets according to residual maturity or next pepricing period, whichever is earlier. An asset or liability is treated as rate sensitive if
Within the time bucket under consideration, there is a cash flow;
The interest rate resets / reprices contractually during the time buckets;
Administered rates are changed, and
It is contractually prepayable or withdrawal allowed before contract maturities.
Thus, Gap = RSA - RSL; Gap Ratio = RSA/ RSL. This gap is used as a measure of interest rate sensitivity. The positive or negative gap is multiplied by the assumed interest changes to derive the Earnings at Risk (EAR). A bank benefits from a positive gap(RSA>RSL) , if the interest rates rise. Similarly, negative gap(RSA<RSL) is advantageous during the period of falling interest rate. The interest rate risk is minimized if the gap is near zero. Gap analysis was widely adopted by financial institutions during the 1980s. When used to manage interest rate risk, it was used in tandem with duration analysis. Both techniques have their own strengths and weaknesses. Duration analysis summarizes, with other term structure movements, such as tilts or bends. It also assesses a greater variety of term structure movements.
Table 2 provides the base data from which all calculations are done. The procedure adopted for breaking up of assets and liabilities and rates of interests has been depicted in Table 3:
Rate Sensitive Assets (RSAs) to Fixed Rate Assets (FRAs) trend of the bank stands at 85:15. Earning assets have been classified accordingly. Rate Sensitive Liabilities (RSL) have been arrived at from the residual maturity statement contained in the annual reports of the respective years by adding the figures under the buckets 1- 14 days to 6 months to 1 year.
Uniform rate of interest has been assigned for RSA and FRAs and this has been followed for RSLs and Fixed Rate Liabilities (FRLs).
Interest rate for assets has been arrived at taking into account advances and investment portfolio and the interest earnings of the bank for the respective years i.e.
Interest Rate = (Interest Earned) / (Total Advances - NPA + Total Investments).
Interest rate for liabilities has been arrived at taking into account the deposits and borrowings portfolio and the Interest rate for assets has been arrived at taking into account advances and investment portfolio and the interest earnings of the bank for the respective years i.e. Interest Rate = (Interest Expended) / (Total Deposits + Total Borrowings)
Experimentation Methodology
Following is the procedure followed for calculating the items in the coming tables:
Initial Performance Measures: From Table 3, the initial position measures regarding the Net Interest Income (NII), Net Interest Margin (NIM), Gap and Net Income (NI) for 2005-06 to 2007-08 are arrived. The formulae used are
NII = (Rate of RSA * Volume of RSA) + (Rate of FRA * Volume of FRA) - (Rate of RSL * Volume of RSL) - (Rate of FRL * Volume of FRL)
NIM = NII / Total Performing Assets
GAP = RSA - RSL
NI = NII - Provisions and Contingencies
Comparative - Static Experiment: Both negative and positive shock of 200 basis points (2%) were introduced without any balance sheet adjustment, i.e., volumes and mix remain constant. The new performance for NII, NIM and NI are calculated for 2004-05 to 2006-07.
Portfolio Adjustment to Rate Changes: RSL increases to RSA as non - interest bearing liabilities and fixed rate liabilities decline. Thus, the new GAP = 0. The performance measures such as NII, NIM and NI are arrived after portfolio rebalancing in Table 4.
Market Force Counter Balance: Market forces drive RSA to increase as (Non Earning Assets) NEA and FRA decline. The GAP after market counter balance is arrived. The performance measures such NII, NIM and NI are arrived after portfolio counterbalancing in Table 4.
The GAP in the initial position at Rs. 21, 66, 712 million, the NII Rs. 1, 55, 890 million, NIM at 3.8 per cent and NI at Rs. 86, 966 million for year 2005-06. When interest rate negative shock of 2% was applied, it reduced the NII to Rs. 1, 12, 556 million, NIM to 2.7 per cent and NI to Rs. 43, 630 million. Then portfolio adjustment is done. Even after this, the initial position can't be obtained. Thus, portfolio adjustment should be carried out in a better way i.e. by aiming at high yielding advances. When counter balancing marketforces are applied, negative shock increased the NI to Rs. 97, 763 million and the positive shock increased the NI to Rs. 1, 06, 375 million. Thus, the negative shock has brought down the NI and positive shock has increased the NI. The portfolio adjustment could not increase the NI to its original position. However, the counter balancing market forceshave enebled the NI to increase in both negative and positive shock scenarios.
