It is very common to hear the following situation anywhere between any two enlightened Ph.Ds. or retired senior citizen or two bank customers renewing their fixed deposits, discussing heatedly, of late, about the rapid falling in rate of commercial banks’ rate of interest, notwithstanding the happy news of the Prime Minister’s assurance on 8% interest on deposits for seniors. Is it political, commercial or wanton care for seniors which resulted in above developments?
Yes, a common man needs an answer, however, unpalatable, it may be.
Luckily, the situation is based on monetary or efficient running of the banks’ considerations relied upon the guidelines of Reserve Bank of India on interest rate risk issued from time to time to commercial banks.
The following article is totally based upon Reserve Bank India’s (RBI) guidelines issued to commercial banks on February 2, 2017 on “Interest Rate Risk in Banking Book” (IRRBB). Interestingly, even though it was intended for Managing Director/CEO’s of all Scheduled Commercial Banks (excluding Regional Rural Banks), it was also put on its web site for a common man to view, understand and appreciate the recent developments on rate of interest paid on deposits, advances or securities held for commercial purposes.
Let us delve directly into the subject.
What is Interest Rate Risk in Banking Book?
Quoting from RBI guidelines,” Interest Rate Risk is the risk where changes in market interest rates affect a bank’s financial position. The changes in interest rates impact a bank’s earnings (i.e. reported profits) through changes in its Net Interest Income (NII) and also impact Market Value of Equity (MVE) or Net Worth through changes in economic value of its rate sensitive assets, liabilities and off-balance sheet positions. The interest rate risks, when viewed from these two perspectives, are known as ‘earnings perspective’ and ‘economic value perspective’, respectively. Generally, the former is measured using the Traditional Gap Analysis (TGA) and the latter is measured by using more sophisticated methods like Duration Gap Analysis (DGA). The present RBI guidelines on IRR require banks to carry out both the analyses.
The focus of the TGA is to measure the level of a bank’s exposure to interest rate risk in terms of sensitivity of its NII to interest rate movements over a period of one year. It involves bucketing of all rate sensitive assets (RSA) and rate sensitive liabilities (RSL) and off balance sheet items as per residual maturity/ re-pricing date in various time bands and computing Earnings at Risk (EaR) i.e. loss of income under different interest rate scenarios over a time horizon of one year.
The focus of the DGA is to measure the level of a bank’s exposure to interest rate risk in terms of sensitivity of MVE to interest rate movements. The DGA involves bucketing of all RSA and RSL as per residual maturity/ re-pricing dates in various time bands and computing the Modified Duration Gap (MDG). The RSA and RSL include the rate sensitive off balance sheet asset and liabilities. MDG can be used to evaluate the impact on the MVE of the bank under different interest rate scenarios.”
Banks are required to compute capital requirements for interest rate risk under Pillar 2 of Basel 3 Capital
Regulations, banks are required to identify the risks associated with the changing interest rates on its on-balance sheet and off-balance sheet exposures in the banking book from both, short-term and long-term perspectives. A level or interest rate risk, which generates a drop in MVE (Market Value of Equity) of more than 20% with an interest rate shock of 200 basis points, is treated as excessive and such banks may be asked by RBI to hold additional capital against IRRBB.
In a simple man’s point of view, the banks are expected to save their capital and earnings from adverse movements of interest rates. We all know that when interest rates change, say, out of changes in deposits, advances or early withdrawal of deposits or early payment of advances, the present value and timing of cash flows change.
Or simply put, excessive IRRBB can affect the capital base and or future earnings, if timely action is not taken. It arises because interest rates can vary significantly over time, while the banking, as a normal business activity, produces exposures to both maturity mismatch (long term assets funded by short term liabilities) and rate mismatch (fixed rate loans, like car loans, being funded by short term deposits of various duration). Further changes in deposit rates or changes in bank’s lending rates may also trigger many unforeseen developments.
What are the enhanced guidelines for banks on IRRBB?
Expectedly, the writer of this article has given below the information conveyed by RBI to the scheduled commercial banks on IRRBB. His communication in simple English is intended to explain complicated RBI guidelines in a lay man’s language. Yes, it helps the readers to prepare for the future shocks which may encroach him by the way of sudden jerks in bank deposits/advances related information
Governance: The banks are expected to have defined risk appetite for IRRBB duly approved by their Board with checks and balances. It clearly specifies the aggregate limit of amount acceptable to the bank as a whole and the individual entities as well. The specific changes in scenarios are linked to the changes in interest even under shock and stress scenarios taking into account historical interest rate volatility and the time required by the bank to mitigate those risk exposures. The following additional information may help:
- The bank’s board to specifically approve the level of IRRBB and to get periodical reports in this regard.
- The banks to have clearly defined procedures to approve major hedging or risk-taking initiatives in advance of implementation.
- The banks to regularly monitor the evolution of hedging strategies to control mark-to-market risks in instruments that will be evaluated at market value
Measurement: Banks are required to compute IRRBB according to hypothetical and historical interest rate scenarios based on their risk profile. RBI has given 6 prescribed risk rate shock scenarios for the guidance of the banks. It has also given a standardized methodology to compute IRRBB from the perspective of EVE. Obviously, the writer has no intention to explain those scenarios elaborately in this article. Those interested can refer to RBI directive whose reference has been given at the end of this article.
Assumptions required for computation of IRRBB: Product wise suggestions are as under:
- Fixed rate loans subject to prepayment risk – loan size, loan to value ratio, borrower characteristics and other location, maturity or historical factors are to be studied
- Fixed rate loan commitments – borrower size, geographical location, term of repayment is to be taken into consideration.
- Term deposits subject to redemption risk early – factors like deposit size, depositor characteristics, location or the competitive market characteristics may be studied
- Banks exposed to various currencies and countries are likely to study IRRBB in each currency and country of exposure.
Overall, the banks are expected to have a sound system of evaluation, analysis and qualified personnel motivated at various levels to study IRRBB at various periods of its functioning, have an effective follow-up procedure and report to the Board as per approved systems. It is possible most of the Indian banks will have to acquire the intention to adopt to these sophisticated international level situations in view of increased competition and the arrival of other players who compete effectively with banks in their routine domain of operation.
Reporting: Expectedly, the banks are to report periodically to their Board, their reports on periodic model reviews and audits based on present scenarios as compared to the past as well as their projections as evaluated to the present. Never, banks in the past, bothered to calculate the risks associated with routine cancellation of deposits, prepayment of demand loans, term loans or non-availing of sanctioned loan limits. These situations were presumed as routine banking operations without any eventful results. Now, RBI would also invite regular reports, evaluate them during audits and ensure reporting the situations to the common man in the Banks’ balance sheets with adequate details.
Capital for IRRBB under Pillar 2
Some of the instructions given by RBI from above guidelines have been given below almost in similar manner for better understanding:
- Banks through their Board to ensure adequate maintenance of capital to cover IRRBB and its related risks
- Banks to develop their own methodologies for capital allocation, based on risk appetite
- Capital adequacy for IRRBB to be considered in relation to risks that are embedded in banks’ assets, liabilities and off-balance sheet items. For expectations of less future earnings, the banks are expected to consider capital buffers.
- The effectiveness and expected cost of hedging open positions that are expected to take advantage of internal expectations of future interest rates.
RBI has given in the annexure 1, the following interest rate shock scenarios which are as under:
(i) parallel shock up;
(ii) parallel shock down;
(iii) steeper shock (short rates down and long rates up)
(iv) flattener shock (short rates up and long rates down);
(v) short rates shock up; and
(vi) short rates shock down
Required mathematical models for study and application are given in the annexure 2, as per details given below:
(i) Indicative methods for calculating ∆EVE
(ii) Cash flow bucketing
- Table 1: for Indicative table for maturity schedule for notional repricing cash flows
- Table 2. Caps on core deposits and average maturity by category
- Table 3. CPRs under the shock scenarios
- Table 4. Term deposit redemption rate (TDRR) scalars under the shock scenarios
Conclusion
The purpose of this article is carry the reader through the interesting developments in Indian banking amidst the competitive market conditions, based on varied deposit/advances/hedging situations which change drastically in Indian/International markets which were previously considered as normal banking challenges. The Indian banking Boards were not exposed to the modern scenarios since the banks made good money and the risks involved were not huge. Though the guidelines given by RBI are yet to be finalized based on receipt of views of all scheduled commercial banks, the author has the courage to expose an average reader to the perils of modern banking as visualized by RBI, particularly in view of Pillar 2 of Basel 3 Capital regulations and valuation of hedging strategies that rely on instruments such as derivatives and to control mark-to-market risks in instruments that are accounted for at market value in terms of Ind AS accounting standards which have been adopted by Indian banks due to recent RBI guidelines.
Though this article may look like a serious one, it simply answers the queries of an average senior citizen why the commercial banks bothered to change interest rates on deposits regularly kept by them for investment purposes.
About the author: Subramanian Natarajan C.P.A. (USA), M.Sc., CAIIB took voluntary retirement in 2000 from Punjab National Bank after handling various facets of banking like deposit mobilization, foreign exchange, auditing and borrower accounts. After living in USA for 12 years during which period he worked in international auditing firms specializing in international tax, auditing, IFRS etc., he continues his practice in New Delhi, India. He can be reached at subcpa@gmail.com. Tel: 7503562701, 9015613229. He currently lives in Delhi. His name appears as tax consultant in web site of American embassy, New Delhi. He is thankful to various suggestions received from readers and is delighted to see the enormous enthusiasm of readers.
Reference
- https://rbi.org.in/scripts/Bs_viewcontent.aspx?Id=33089
- (Draft guidelines on governance, measurement, and management of Interest Rate Risk in Banking Book)
- “Statement on Development and Regulatory Policies” by RBI dated October 4, 2016 available from rbi.org website.
- If passages have been quoted from the original, credits have been given.
About the author : Subramanian Natarajan C.P.A. (USA), M.Sc., CAIIB took voluntary retirement in 2000 from Punjab National Bank after handling various facets of banking like deposit mobilization, foreign exchange, auditing and borrower accounts. After living in USA for 12 years during which period he worked in international auditing firms specializing in international tax, auditing, IFRS etc., he continues his practice in New Delhi, India. He can be reached at subcpa@gmail.com. Tel: 7503562701, 9015613229. He currently lives in Delhi. His name appears as tax consultant in web site of American embassy, New Delhi. He is thankful to various suggestions received from readers and is delighted to see the enormous enthusiasm of readers.
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