The potential loss resulting from unforeseen changes in interest rates which can change profitability of a bank is known as interest rate risk.
Types of Interest rate risk:
Spread Risk (reinvestment rate risk)
The change in banks cost of funds as well as the return on their invested assets due to the result of variations in interest rates is termed as Spread Risk. They may or may not change by different amounts.
Price Risk
The change in market value of banks assets and liabilities by different amounts/ratios due to change in interest rates in known as price risk. The longer the duration, the higher will the impact on value for a given change in interest rate.
Measuring IRR with Gap analysis
As the name indicates, it refers to comparing actual performance to its expected performance. By careful analysis of these gap, the company can effectively create a realistic action plan to address the breaks and thus improve the performance.
The impact of IRR
Interest rate risk can affect in two ways:
The most immediate impact would be on Net Interest Income (NII). However, if interest rates continue to change for a longer duration the long term impact would be on bank’s balance sheet. As a result, it will influence bank’s net worth, assets, liabilities and its off-balance sheet positions due to changes in interest rate levels.
As, NII is directly dependent on the patterns of interest rates, any mismatches in cash flow debunks NII vulnerability to the interest rate variations.
With this, the earning of assets and the cost of liabilities are carefully linked to volatility in market interest rate.
There are two ways in which we can view interest rate risks:
Earnings Perspective
Under this method, the difference between net interest income and interest expense is measured. This sensitivity analysis further extends GAP analysis to include changes in bank earnings due to variations in interest rates and balance sheet structure.
Economic Value Perspective
With this approach, analysis is carried out to compute the impact of interest rates on banks net worth. This is calculated by expected cash flows on assets less expected cash flows on liabilities plus the net cash flows on off-balance sheet items. This perspective classifies risk arising from interest rate gaps in the long term. Also, the net change in economic value is usually expressed as a percentage of assets.
To simplify it, this perspective thrives on gap analysis. The process involves grouping assets and liabilities on the basis of their maturity period. Say for example, 1m, 2m and so on. For each duration, you identify the gap by deducting liabilities value from assets value. If the gap is negative, it depicts that banks are more vulnerable to interest rates.
A slightly more complicated process, normally adapted by regulatory authorities is a more complicated version of gap analysis. The process starts with computing the change in the values of assets and liabilities within each time duration for a change in interest rate. The next step would be to find out the total difference between the two. This indicates the loss banks have to face if interest rates go against the expectations.
Why Banks can’t afford to miss IRR?
Since, IRR can have a negative impact on bank’s net worth and earning over the long term, Banks can take several steps to mitigate IRR.
With the prominence and availability of sophisticated technology, banks can measure Interest rate risks on real time basis. They can also enter into financial contracts (IRS and other strategies) to pass on the IRR to the party who can manage it. It is very important to compute risk-returns trade-offs. Banks should be able to receive acceptable returns for the risks they incur.
