Lloyds TSB Bank Plc was established in 1995 following a merger of Lloyds Bank with TSB group, established in 1765 and 1810 respectively. It has its headquarters in London and Edinburgh, UK. The bank provides complete range of banking and financial services and has a wide network of branches in England, Wales and Scotland.
The Royal Bank of Scotland Plc, NatWest and Ulster Bank are the retail banking subsidiaries of ROYAL BANK OF SCOTLAND GROUP PLC. The group has its network and branches throughout the British Isles. The bank was established in 1727 and it was the first bank to provide overdraft facility.
Interest rate risk is the risk to which an institution is exposed because future interest rates are uncertain and is incurred by a financial institution when the maturities of its asset and liabilities are mismatched.
To measure the interest rate risk exposures, two most commonly used models by FIs are:
Repricing or Funding Gap Model,
Duration Model.
But, because of its simple approach and insufficient data we have used Repricing Model in order to measure the interest rate risk exposures of the two banks.
Repricing Model:
Concept:
This Model is basically based on the repricing gap i.e. the difference between rate-sensitive assets and rate sensitive liabilities over a particular period of time, which shows the risk exposures of the banks and when this gap is multiplied by the change in interest rate it gives the net change in interest income of the banks, that determines how much a bank will lose or earn due to change in interest rates.
Formula Used:
∆ NIIi = (GAPi) ∆Ri = (RSAi-RSLi) ∆Ri
GAP RATIO = CGAP/ASSET
∆ NII=Change in net interest income, ∆R=Change in interest rate, i=Maturity bucket
GAP=Gap between rate-sensitive assets and rate sensitive liabilities.
Methodology:
To compute the risk exposures of two banks we have assumed that:
Change in Interest rate is the change in 1 yr LIBOR RATE(Shown in table 1)
Change in interest rate affects all the rate sensitive asset and liabilities equally.
We have calculated the exposure over 1-year maturity bucket.
Table: 1 Change in LIBOR
For 2005
1.8992%
For 2006
1.2557%
For 2007
-.2215%
For 2008
-2.0498%
For 2009
-1.5034%
Looking at the previous Financial Statements for last five years of the Lloyds TSB Bank and Royal Bank of Scotland Group, we have found out the GAP and CUMULATIVE GAP for last five years over one year maturity bucket between the rate sensitive assets and rate sensitive liabilities which gives us the risk exposures of the two banks for last five years. The GAP for each year when multiplied by the change in LIBOR rate of that particular year gives the NET CHANGE IN INTEREST INCOME of the banks for that year.(Shown in tables 2 & 3)
Cumulative gap has also been expressed in ratio to asset size, called the gap ratio, which determines the direction of the risk exposure and also relates the exposure to the size of banks total assets.
Table 2: Interest Rate Exposure of RBS
Year
Duration
GAP
C.GAP
∆ NII
% GAP Ratio
2009
1Day - 3 Mnth
-450777
-450777
3 mnth-1 yr
-63
-450840
6777.93
-26.5749
2008
1Day - 3 Mnth
-510855
-510855
3 mnth-1 yr
12391
-498464
10217.52
-22.4665
2007
1Day - 1 yr
-470881
-470881
1043
-24.7764
2006
1Day - 3 Mnth
-52931
-52931
3 mnth-6 mnth
12639
-40292
6mnth- 1 yr
6236
-33966
-426.51
-3.8977
2005
1Day - 3 Mnth
-47261
-47261
3 mnth-6 mnth
10139
-37122
6 mnth-1yr
4782
-32340
-614.20
-4.1630
Table 3: Interest Rate Exposure of LloydsTSB
Year
Duration
GAP
C.GAP
∆ NII
% GAP Ratio
2009
1Day - 3 Mnth
-364454
-364454
3 mnth-1 yr
-29108
-393562
5917
-38.3120063
2008
1Day - 3 Mnth
-157435
-157435
3 mnth-1 yr
3990
-153445
3145
-35.1911438
2007
1Day - 3mnth
-135860
-135860
3mnth-1yr
-167
-136027
301
-38.4965006
2006
1Day - 3 Mnth
-70157
-70157
3 mnth-1yr
11355
-58802
-738
-17.1136037
2005
1Day - 3 Mnth
-44377
-44377
3 mnth-1yr
15619
-28758
-546
-9.28414161
Findings, Conclusion & Recommendations:
Cumulative GAP for each year of both the banks was negative, over one year maturity bucket, it points that rate sensitive liabilities for both banks were greater than its rate sensitive assets.
The comparison of risk exposure of both the banks shows that in the year 2005 both the bank had almost same risk exposure. However, in the last three years RBS had much greater interest rate risk exposure as compared to the LloydsTSB.
Now comparing change in net interest income, for year 2005 and 2006 it was negative for both the banks because during these years the change in LIBOR rate was positive and for later years change in net interest income was positive for both the banks where RBS dominated Lloyds, as the change in LIBOR was negative.
So, looking at above data and graphs, we can conclude that though the RBS was more exposed to interest rate risk, they had positive and higher net interest income than Lloyds and that was because they had more rate sensitive liabilities which gave them more interest income as rates went down in those years.
Regardless of interest rate movement, exposure to risk is always dangerous so both the banks can hedge their interest rate risk by using interest rate swaps or fixed income instrument.
Limitations of Repricing model
The repricing model is much simpler to apply than duration but it has certain limitations such as:
It ignores the market value effect.
Problems of Runoffs.
Cash flows from the off balance sheet activities are not taken into account i.e. RSAs and RSLs used in the model are only the asset and liabilities listed on the balance sheet.
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