Interest risk management by the banks
Sunday, 19 August 2007
Ahmed Showkat Masud
WHEN interest rate changes in the money market, bankers face interest rate risk. Banks' revenue comes from interest income from investment activities. Their expenses are incurred to meet interest cost on deposits. Interest rate changes in the money market change the market value of banks' assets and liabilities. In this way, with the change of market interest rate, banks' net worth also changes.
Since the market interest rate is determined by the monetary policy of the central bank, commercial banks as well as non-banking financial institutions have nothing to do except to make adjustment of their interest rates for lending, and on borrowed funds. Each bank reacts to the level of, and trend in, interest rate in the money market to maximise the profit. When market interest rate rises, market values of fixed-rated loans invested by banks as well as NBFIs fall. In this situation if the central bank directs the commercial banks and NBFIs not to increase the lending rate on industrial loans as well as credits for commercial and service sectors, the lending institutions will have to accept capital losses. To offset the losses, the lenders will have to decrease the interest rate on deposits.
Market values of fixed interest-bearing bonds will fall. If the central bank opts for contractionary monetary policy for a long time, then the commercial banks and NBFIs face liquidity problems. To overcome this problem, they will borrow money at high rate of interest that will raise lending rate in support of investment activities.
To recoup the expected losses due to rise in market-based interest rate, the lending institutions will have to use discount rate that equalises the current market value of total investment with the expected income to be generated from investment activities. Loan portfolio mix includes investment loans of different maturities. Therefore, yield to maturity will have to be calculated for the expected cash flow of different tenor. For example, term loans for five years will generate income for five years tenor. Expected cash flow for the first to the fifth year will have to be calculated to equate the current market price of the amount of term loans so that the lender can avoid any loss.
Since banks' portfolio of assets and liabilities are sensitive to interest rate movement, the management seeks to hold the banks' net interest margin, fixed. If the net interest margin is lower, banks' profit will be reduced. Lower net interest margin which will cause lower profit for the banks will be further reduced after deduction of expenses against salaries and expenses against overhead. No matter whether market interest rate goes upward or downward, banks will want to maximise their profit. For this reason, the management must concentrate on the banks' portfolio of assets and liabilities and their extent of sensitiveness to the interest rate movements. To protect the goal of achieving the desired level profit, the management will have to use a variety of interest rate hedging methods.
When the economy faces a hyperinflation rate which may be aggravated by the countrywide flood, many lenders will conclude that some businesses will fail, particularly those who are running their operations in the flood-hit areas, in both manufacturing and service sectors. Agricultural sector will be affected severely. It will cause the affected borrowers to become defaulters. The default-risk premium component will cause the lending rate to become high. On the other hand, rising prices of goods may cause the lenders to expect a trend toward higher inflation. This will reduce the purchasing power of their amount of loans. That is, borrowing money will then be costlier. To offset the loss, they will have to take a higher inflation-risk premium from the borrower.
To safeguard the banks' interest by maximising profit, the management will have to be more cautious about over the volume and mix of their credit portfolio, and interest income and expenses of both assets and liabilities. Effective control in managing the components of assets and liabilities will have to be there so that the spread between banks' revenue earning and operational expenses can help achieve the desired profit. Hedging interest risk requires a special attention.
(The writer works with ONE Bank Ltd., Khatunganj Branch, Chittagong)
WHEN interest rate changes in the money market, bankers face interest rate risk. Banks' revenue comes from interest income from investment activities. Their expenses are incurred to meet interest cost on deposits. Interest rate changes in the money market change the market value of banks' assets and liabilities. In this way, with the change of market interest rate, banks' net worth also changes.
Since the market interest rate is determined by the monetary policy of the central bank, commercial banks as well as non-banking financial institutions have nothing to do except to make adjustment of their interest rates for lending, and on borrowed funds. Each bank reacts to the level of, and trend in, interest rate in the money market to maximise the profit. When market interest rate rises, market values of fixed-rated loans invested by banks as well as NBFIs fall. In this situation if the central bank directs the commercial banks and NBFIs not to increase the lending rate on industrial loans as well as credits for commercial and service sectors, the lending institutions will have to accept capital losses. To offset the losses, the lenders will have to decrease the interest rate on deposits.
Market values of fixed interest-bearing bonds will fall. If the central bank opts for contractionary monetary policy for a long time, then the commercial banks and NBFIs face liquidity problems. To overcome this problem, they will borrow money at high rate of interest that will raise lending rate in support of investment activities.
To recoup the expected losses due to rise in market-based interest rate, the lending institutions will have to use discount rate that equalises the current market value of total investment with the expected income to be generated from investment activities. Loan portfolio mix includes investment loans of different maturities. Therefore, yield to maturity will have to be calculated for the expected cash flow of different tenor. For example, term loans for five years will generate income for five years tenor. Expected cash flow for the first to the fifth year will have to be calculated to equate the current market price of the amount of term loans so that the lender can avoid any loss.
Since banks' portfolio of assets and liabilities are sensitive to interest rate movement, the management seeks to hold the banks' net interest margin, fixed. If the net interest margin is lower, banks' profit will be reduced. Lower net interest margin which will cause lower profit for the banks will be further reduced after deduction of expenses against salaries and expenses against overhead. No matter whether market interest rate goes upward or downward, banks will want to maximise their profit. For this reason, the management must concentrate on the banks' portfolio of assets and liabilities and their extent of sensitiveness to the interest rate movements. To protect the goal of achieving the desired level profit, the management will have to use a variety of interest rate hedging methods.
When the economy faces a hyperinflation rate which may be aggravated by the countrywide flood, many lenders will conclude that some businesses will fail, particularly those who are running their operations in the flood-hit areas, in both manufacturing and service sectors. Agricultural sector will be affected severely. It will cause the affected borrowers to become defaulters. The default-risk premium component will cause the lending rate to become high. On the other hand, rising prices of goods may cause the lenders to expect a trend toward higher inflation. This will reduce the purchasing power of their amount of loans. That is, borrowing money will then be costlier. To offset the loss, they will have to take a higher inflation-risk premium from the borrower.
To safeguard the banks' interest by maximising profit, the management will have to be more cautious about over the volume and mix of their credit portfolio, and interest income and expenses of both assets and liabilities. Effective control in managing the components of assets and liabilities will have to be there so that the spread between banks' revenue earning and operational expenses can help achieve the desired profit. Hedging interest risk requires a special attention.
(The writer works with ONE Bank Ltd., Khatunganj Branch, Chittagong)