Interest Rate Risk Management Programmes

PURPOSE

An Interest Rate Risk Management Programme or Interest Rate Risk Management Policy is a document setting out the minimum policies and procedures that a financial institution will apply to prudently manage and control its exposure to interest rate risk.

The responsibility for the administration of an institution's Interest Rate Risk Policy normally rests with the Treasury Department reporting usual to the Asset Management or Financial Control Division.

The Treasury Department along with an assets and liabilities committee (ALCO) have ultimate responsible for the  institution's assets and liabilities and ultimately it's interest rate risk management.

They meet periodically to review overall asset and liability issues. The Interest Rate Risk Management aspect of the meeting entails reviewing :

• A Cost of Funds Report

• GAP Report

• Interest Rate Sensitivity Report 
  

Any deviation from expected results or guidelines are escalated to the monthly Board Meeting.

DEFINITION

Interest rate risk is the potential impact on an institution’s earnings and net asset values of changes in interest rates. Interest rate risk occurs when principal and interest cash flows (including final maturities), both on and off-balance sheet, have mismatched re-pricing dates. The level of risk is a function of the size and direction of the interest rate changes and the maturity structure of the mismatch position.

Interest Rate Risk Philosophy

Banks will typically have a general statement outlining its overall approach and management of interest rate risk. Example of general statement:

"ABC Bank Ltd will at all times seek to minimise or totally eliminate interest rate risk by having a fully matched position".

The dynamic environment in which financial institutions operate, the statement will then go on to outline how it will handle market realities, challenges and exceptions. here are a few additional statements that may accompany the bank's overall philosophy:

• The inherent nature of the money and capital markets is such that investors have a very short-term investment horizon (1- 3 months) while assets are typically longer term in tenor (1 – 7 years).

• If rates are expected to decline the bank will position itself in longer term assets funded by short-term liabilities..

• The Bank, in general, will better control its interest rate risk with a larger proportion of its funding being drawn from individuals and smaller institutions (instead of institutional clients) as this is normally cheaper and more stable. The portfolio’s target mix is a 75/25 split between individual and institutional clients.

The Use of Other Risk Management Programmes

The bank's interest rate risk is managed in conjunction with various internal programmes, such as capital risk management and also through explicitly stated policies, in assuming risk in its strategic business units.

Capital Risk Management

Capital risk is an institution's ability to absorb and survive losses based upon its capital base. Capital Risk management is an integral part of an institution's overall Risk Management Programme.

The Risk Management programme seeks to:

Establish a adequate capital position to inter alia absorb potential losses from unfavourable swings in interest rates;

Provide liquidity and source of funding for longer term instruments.

Liquidity Management

Liquidity management is also key in managing the Bank’s interest rate risk. Firstly, the Bank may have strict guidelines as to minimum cash positions given certain situations. This cash may be placed on an overnight or call basis.

Additionally, apart from the cash holdings, the liquidity program may stipulate that at least 25% of the banks' asset portfolio must be placed in short-term interest bearing instruments (30 – 90 days) to essentially match the demands of its short-term liabilities.

The bank's overall target asset mix the could be as follows:

10% Cash or call/overnight placements 

25% invested in short-term (30 - 90days) interst-bearing government securities

25% invested in securities maturing in 1 year

20% in medium-term securities (1 - 5 years)

20% in long-term securities (7yrs and longer) 

Credit Risk

A credit risk is the potential for financial loss resulting from the failure of a debtor, for any reason, to fully honour financial or contractual obligations. When debtors are unable to adequately service credit facilities it restricts the Bank’s ability to book new loans or re-price to offset rising interest costs. This therefore exposes the Bank to interest rate risk. In order to manage credit risk and ultimately interest rate risk, the Bank is guided by strict Credit and Investment procedures that are documented in its Policy and Procedures Manual.

Investment Risk

This is the exposure of the institution to the effect of interest rate changes on the market value of the institution’s fixed rate assets and liabilities. Increases in interest rates will result in a lowering of the price of assets. While this may positively affect interest spreads, the market value of fixed rate assets will decrease.

In markets where interest rates are prone to unexpected swings, the bank's policy maybe to only hold fixed rate assets for trading purposes.That way, unfavorable swings can be mitigated by the timely selling of the pool of fixed rate instruments.

Forex Risk 

This is the exposure of the institution to the potential impact of movements in foreign exchange rates. In the day to day management of forex risk, the bank may decide that short position in it's forex holdings, given a stable rate of exchange is desirable the interest rate on base currency is increasing.

Let's consider a Canadian bank where the CAD is the base and with some of it's assets held in USD instruments. If the interest rates on CAD investments start rising and providing the exchange rate between the USD and CAD is stable or stable or being revalued, the bank can decide  convert US$ funds to take advantage of higher interest rates in the CAD market.

This arbitrage position (which is rear in developed markets) is then reversed as soon as 1) CAD investment rates are expected to fall 2) The CAD currency is expected to devalue, in order not to eliminate any gains made from the arbitrage.

Measuring Interest Rate Risk

There are several methods of measuring the interest margin – Gap analysis, Duration analysis and Simulation models. Due to the more complex nature required to design the latter two, smaller banks in particular tend to utilise the Gap Analysis.

*****

GLOSSARY

The management and control within set parameters, of the impact of changes in the volume, mix, maturity and quality and interest and exchange risk sensitivity of assets and liabilities on the institution.

The present-value-weighted average term to repricing of the series of cash flows. It is the measure of the average term to repricing of a series of cash flows.

Foreign Exchange Risk

The exposure of the institution to the potential impact of movements in foreign exchange rates. Foreign exchange risk arises when there are unhedged currency mismatches in an institution’s assets and liabilities, and related cash flows which are not subject to a fixed exchange rate vis-à-vis the Jamaican dollar. This risk continues until the open position is covered by means of a hedging transaction. The amount at risk is a function of the magnitude of the potential exchange rate changes and the size and duration of the foreign currency exposure.

The Funds Gap
This refers to the amount by which sensitive assets exceed sensitive liabilities.

GAP Analysis

A analysis of the difference between the amount of rate-sensitive assets and rate-sensitive liabilities repriced within a given period.

The potential impact of movements in interest rates on the institution.

The amount of the institution’s exposure to interest rate risk.

Interest-earning assets and interest-bearing liabilities that mature or are repriced within specific time periods or have interest rates that float in relation to a base rate such as the prime rate.

The difference between the yield on the institutions earning assets and the cost of its interest bearing liabilities.

It is the exposure of the institution to the effect of interest rate changes on the market value of the institution’s fixed rate assets and liabilities.

Liquidity is the availability of funds, or assurance that funds will be available, to honour all cash outflow commitments as they fall due. These commitments are generally met through cash inflows, supplemented by assets readily convertible to cash or through an institution’s capacity to borrow. The risk of illiquidity may increase if principal and interest cash flows, related to assets and liabilities are mismatched.

A matched position occurs when an institution’s principal and interest cash flows have matched repricing dates.

Also referred to as an interest rate gap or interest rate sensitive position. This occurs when the principal and interest cash flows have differing repricing dates.

A negative or liability sensitive gap occurs when more liabilities are repriced than assets within a specific maturity period.

A positive or asset sensitive gap occurs when more assets repriced that liabilities within a specific maturity period

The process of controlling the impact of risk-related events on the institution.

A statement of principles and objectives that outlines the institutions willingness to assume risk. An institution’s risk philosophy will vary with the nature and complexity of its business, the extent of other risks assumed, its ability to absorb losses and the minimum expected return acceptable for the specified level of risk.

The dollar amount of the institution’s exposure to a particular risk.

A dynamic analysis of the interest rate risk on an institution arising from both current and future business, including the effects of strategies to increase earnings or reduce interest rate risk.