Interest Rate Risk is the risk of loss of a bank's current and future income and the risk of erosion in the value of assets and liabilities on account of movement in the interest rates. Fluctuations in interest rates affect Interest-sensitive income and expenses which may adversely affect the earnings (Net Interest Income) of banks and financial Institutions (FIs). The changes in the value of cashflow results into changes in underlying value of a bank’s assets, liabilities, and off-balance sheet items and hence its economic value. Interest rate changes have bearing on the capital as it affects the cashflows and values of future cash flows. Thus, changes in Interest can adversely affect liquidity, earnings, capital, and solvency of banks and FIs.
Changes in interest rates impact a bank’s earnings (i.e. reported profits) through changes in its Net Interest Income (NII). Changes in interest rates also impact a bank’s Market Value of Equity (MVE) through changes in the economic value of its interest rate sensitive assets, liabilities and off-balance sheet positions. The interest rate risk, when viewed from these two perspectives, is known as ‘ earnings perspective’ and ‘econ omic value perspective’ , respectively.
Interest rate risk affects both trading book and banking book of the banks. Interest Rate Risk is prevalent on both the asset as well as the liability sides of the bank’s Balance Sheet.
Banks need to develop risk mitigation methodologies to minimise the volatility in its earning and value of its equity. Developing effective interest rate risk management tools mandates, a thorough understanding of interest rate risk. Bankers manage interest rate risk by performing analyses like VaR, basic gap analysis and duration analysis, which accounts for the fact that bank assets and liabilities have different maturities. Such analyses combined with interest rate predictions, guide bankers when to increase or decrease their rate sensitive assets or liabilities or whether to shorten or lengthen the duration of their assets or liabilities.
The increased volatility in the market has made the interest rate risk more challenging. In this course we shall endeavour to understand the concept of “Interest Rate Risk, its impact on bank’s earnings and financial health and various tools used to manage interest rate risk in banks and financial institution.
