Key Components of Interest Rate Risk and Approaches of Risk Management for Chinese Banks - Essay Example

Analysis of the Key Components of Interest Rate Risk and Evaluate the Approaches of Risk Management for Chinese Banks Contents Introduction 3 Discussion 3 Key Components Associated with Interest Rate Risk 3 Maturity Mismatches 3 Basis Value Risk 4 Yield Curve Risk 4 Optionality 4 Prepayment or Extension Risk 4 Real Interest Rate and Risk Free Interest Rate 5 Expected Inflation 6 Liquidity Premium 6 Maturity Risk 6 Impact of Interest Rate Risk on Banking Sector 7 Chinese Banking Sector and Its Approaches to Manage Interest Rate Risk 7 Gap Analysis 8 The Duration Model 8 Internal Audit and Control 9 Conclusion 9 Reference List 10 Introduction Dynamism of the financial markets and structural transformations in balance-sheet and off-balance sheet activities of the banking sector tends to expose the financial systems of the economy to various interest rate risks. Interest rate risk arises when the return from the investment changes due to fluctuations in the interest level (Yao, 2012). Though the degree of interest rate risk is considerably less significant than credit risk, this kind of risk is considered to be much critical as the widespread effect of such risks affects the society and the economies at large. The type of risk tends to affect the stock and bond market in different ways (Hammond, Kanbur and Prasad, 2009). However, as the interest rate risk impacts the bond market negatively, the investors shift their investment pattern from bond market to equity market, influencing performance of this segment of financial market (Fabozzi, 2008). In this paper, the key components of interest rate risk will be analysed thoroughly. The financial system of China is considered to be one of the highly regulated, involving highly integrated economic and monetary policies. Such regulations and integrations are reflected in the functioning of the banking sector of the country as well (Federal Reserve Bank of San Francisco, 2014). Therefore, for the purpose of analysis, the risk management approaches of the banking sector of China will be critically evaluated. Discussion Interest rate risk is crucial part of any financial system. Therefore, before analysing the key components of interest rate risk, the source of such risks should be identified (Deng, 2011). The fundamental components associated with origination of interest rate risk are as follows: Key Components Associated with Interest Rate Risk The main components attached to risk of interest rate are as follows: Maturity Mismatches Non- alignments arises in the balance sheet and off-balance sheet items of the banking sectors. In case of fixed interest rate, such mismatches originate at the time of maturity of the financial instrument and in case of variable interest rates; the non-alignments arise at the time of revaluation of asset, liabilities as well as off-balance sheet instruments (Deng, 2011). Scope and size of such temporal mismatches make it critical to forecast changes in interest rate which in turn creates huge interest rate risk (Lardy, 2012). Basis Value Risk Basis value risk arises out of the asset liability mismatches. Many a times, the correlation between the value of maturities and revaluation of asset- liabilities and their calculative values becomes highly negative because of the adaptation of interest rates (East Asia Forum, 2014). This kind of risk also changes the index rates used for pricing the liabilities and asset that does not really changes in a concurrent way and originates huge amount of interest rate risk (Li, 2011). Yield Curve Risk Yield curve indicates several possible interest rates across different contract lengths in case of identical debt contracts. It signifies the relationship between interest rate and the term of debt contract or the time to maturity. Yield curve risk becomes prominent when changes in the values and slope of the yield curve capitulates an unfavourable effect on the monetary inflows as well as asset values of the bank (Liao and Tapsoba, 2014). Optionality Optionality indicates the subsistence of interleaved options in the asset-liability and off- balance instruments that leads to create interest-rate risk. Theoretically, options are considered to be a standalone instrument that provides the holder’s right and not the buyer’s obligation to buy, sell or modify the cash flow (Federal Reserve Bank of San Francisco, 2014). Optionality leads to originate interest rate risk because of the fact that utilization of inserted options changes the anticipated level of financial surges from the associated instruments (Ličák, 2004). Prepayment or Extension Risk Prepayment of liabilities can be experienced when the individuals tend to repay assets at the time of low interest rate. Such activities reduce the interest income of the financial systems such as banking sector and in fact create the requirement for reinvestment of the already paid funds (East Asia Forum, 2014). Such risk further strengthens when the bond holders exercise call options for paying off the assets of the bank in advance as a result of decline in the interest rate. Contrasting with prepayment risk, the extension risk originates when individuals delay in payment of assets due to rising interest rate. Such initiatives also ignite interest rate risk as the financial system suffers from lower interest income. It also reduces the availability of funds for investing at higher yields (Nawalkha, Soto and Beliaeva, 2005). The Other Components Associated With Interest Rate Risk Real Interest Rate and Risk Free Interest Rate The real interest rate indicates that rate of interest that the investors expect to receive after considering the provision for inflation. For instance, if an investor invests at an interest rate of 7% and forecasts an increase in the price level of 3%, then the real interest rate for the investor can be 4% (Federal Reserve Bank of San Francisco, 2014). However, incidents are there when the real interest rate has fluctuated substantially due to unanticipated changes in the demand, capital borrowing or inflation in the economy even in the short run. Apart from that, time value of money, changes in the purchasing power in the economy, changes in taxation also influence the real interest rate to change which in turn becomes the precondition for interest rate risk (Yang and Wen, 2014). Moreover, risk free rate of interest promises to pay the investors the rate which is pre-determined by the financial institution at the time of making the investment, no matter the market condition or inflationary pressure. For instance, at the time of investment, if the governing body declares an interest rate of 8%, they are bound to pay the bond holders the same interest rate after the tenure of the bond irrespective of any influence from the internal or external environment (Federal Reserve Bank of San Francisco, 2014). In such circumstances, the investors are affected by interest rate risk due to existence of time value of money and inflation rate. At the time of investment, when the promised interest rate was 8%, the inflation rate was 2%, making the real interest rate to be received by the investors 6%. Because of rising pressure on the price of commodities, at the time of maturity if the inflation rate increases to 4%, the real interest rate received by the investor will become 4% instead of 6%. This is how risk free interest rate initiates interest rate risk for the investors. Risk will be higher if the financial institution defaults at the time of payment of interest and capital as well (Pouzikova, 2000). Expected Inflation As the aggregate price level is expected to increase, the purchasing power of currency tends to reduce due to the effect of inflation rate. However, it is difficult to anticipate exact rate of future inflation because the rate depends upon a number of variables such as degree of economic and political stability, market condition, changes in the transportation cost, seasonality effects, availability of the commodities and many more (Hammond, Kanbur and Prasad, 2009). It becomes difficult to forecast movement of all such variables for the economists; as a consequence, if the inflation rate increases, the interest rates are also augmented by the monetary authorities for restricting money supply. Sometimes, due to high inflation, interest rate is deliberately decreased by the monetary authority so that money supply increases in the economy and the individuals gain a better access to the overpriced goods and services. In this way, inflation rate instigates the interest rate risk (Sun, 2011). Liquidity Premium Some investment instruments such as treasury bills etc. are highly liquid and can be easily swapped in against of cash. An investor may hold other instrument as well which are less liquid because of infrequent trading of such securities. Therefore, tendency is there to compensate the holder by providing a higher interest rate through the less liquid instruments (Hammond, Kanbur and Prasad, 2009). For instance, an investor may be interested in investing in two corporate bonds with identical coupon payment and time of maturity: one is publicly trade and another is non- tradable. Hence, the investor’s tendency will be to invest a lower amount in the non-tradable bond due to lack of liquidity options. Such discrepancies in the interest rate payment due to differences in investment proportion are called liquidity premium and such premium causes for interest rate risk to a great extent (Wang, 2008). Maturity Risk In general, fixed income investments such as bonds pay a fixed rate of interest on the face value and at the time of maturity, repay the principal amount to the investors. The period of maturity ranges from 30 days to over 30 years (Yang and Wen, 2014). Maturity risk arises due to changes in the interest rate as probability is very high for the investors to witness interest rate fluctuations. It has been experienced that higher the tenure of the maturity, higher will be the expected level of fluctuation of interest rate. Investors can earn a maturity premium if the interest rate increases substantially till the time of investment and they may incur maturity discount as well, if the interest rate diminishes. However, exposition to maturity risk is always associated with interest rate risk (Wang, 2010). Impact of Interest Rate Risk on Banking Sector Interest rate risk and various components associated with this leaves a great impact on the banking sector of the financial system. Changes in the interest rate lead to change in the financial flow and asset holding of the commercial banks (East Asia Forum, 2014). Therefore, banks are required to exercise frequent gap analysis, evaluation of the price value on the basis point and other measures for the purpose of obtaining a short term view on the interest rate risk and for formulating strategies to control such risk accordingly (Federal Reserve Bank of San Francisco, 2014). Measuring interest rate sensitivity also aids the banking sector an insight regarding net financial flow in aggregate as an outcome of changes in economic variables. In the next segment, the ability and techniques of Chinese banking system to manage interest rate risk will be evaluated (East Asia Forum, 2014). Chinese Banking Sector and Its Approaches to Manage Interest Rate Risk Chinese banking system is characterised by one of the most synchronized banking sector in the world with existence of six major banks. After undergoing through several reforms, WTO (World Trade Organization) has identified the People’s Bank of China as the country’s central bank (Fung Global Institute, 2015). The People’s Bank of China is solely responsible for controlling the monetary policy and macro economic variables of the country (Deng, 2011). Therefore, the risks arising out of changes in interest rate and other factors are monitored and mitigated by this central bank of the country itself. However, as the asset and liability holding of commercial banks are substantially affected by the interest rate risk, the Chinese commercial banks also take firm steps to minimize such risks (Chen and Yao, 2005). It has been experienced by the experts that the Chinese commercial banks are not only exposed to permanent interest rate risk but also experience periodical risk which is gradually accelerating. For analysing and controlling interest rate risk systematically, the Chinese banking sector opts for sensitivity ratio analysis, gap analysis, two stage strategy and duration technologies (Federal Reserve Bank of San Francisco, 2014). However, as the financial derivative market of China is in its primary stage, it becomes difficult for the policy makers to diverse or shift the interest rate risk because of simplified product structure and imperfect market function. Empirical research of Yang and Wen (2014) on the basis of analysing the data of 7 fundamental banks of China, it has become evident that over the tenure of a year, asset is not equal to the liabilities in those Chinese commercial banks (Bank of China, 2015). Therefore, the following actions have been taken by the banking sector of China to encounter the adverse effect of interest rate risk. Gap Analysis Gap analysis indicates the method of segregating the assets, liabilities and off-balance sheet items that are highly sensitive to interest rate changes and defining the time bands according to their maturity or next revaluation (Fung Global Institute, 2015). The gap between assets and liabilities over a specific time band indicates the intensity of interest rate risk that the Chinese banking system is exposed to (Federal Reserve Bank of San Francisco, 2014). Multiplying the cumulative gaps by the forecasted change in the interest rate, the policy makers aim to explore the impact of the interest rate risk on the country’s financial. Based on the analytical result, the banking sector of China accordingly modifies the monetary policy and increase or reduces the money supply within the economy to control the interest risk (Hammond, Kanbur and Prasad, 2009.). The policy makers of China mainly emphasises on weighted cumulative gap approach to evaluate the risk impact. Similar to any other banking system, as the contemporary Chinese banks also incorporate various volatile products and services such as variable interest rate and inserted options, weighted approach facilitates the policy makers to capture the dynamism in the interest rate, even in the short run and accordingly arrive at a definite result, based on which they can incorporate better controlling measurements (Fung Global Institute, 2015). The Duration Model The banking system of China also exercises duration model to assess, predict and mitigate interest rate risk (Chen and Yao, 2005). In general, it is expected that, longer the tenure of the fixed coupon investment, the higher the sensitivity to interest rate changes. The model provides a time series or expressed in number of years where increasing interest rate indicates declining bond prices (Bank of China, 2015). Calculation of duration induces the Chinese policy makers to go through several complicated calculations that involve analysis of call features, present value, coupon rate, yield and final maturity. The higher the number of years yielded by the duration calculations, the greater the interest rate risks associated with the fixed investments (Haacke and Preston, 2013). Based on this mathematical calculation, empirical evidences have shown that the portfolio duration of 7 fundamental Chinese commercial banks is 5.82. This indicates that as the interest rate increases by 100 basis point, the bond portfolio return decreases by 5.82%, signifying the accounting loss due to interest rate risk exposure (Yang and Wen, 2014). Once the extent of interest rate risk exposure on the Chinese banking system is evaluated, the management and financial experts sort to redesign their hedging strategies in international derivatives market in order to diversify the risk as much as possible (Yao, 2012). Internal Audit and Control Internal and external audit over a period of time brings greater clarity and transparency in the banking regulatory systems and risk management procedure. Relying on such practices, the banking system of China has created provisions for periodic review of the data accuracy in risk measurement tools, alignment of the baking regulations and reporting process with compliance etc (Fung Global Institute, 2015). Such review helps the banking system in China to practice better policy regulations and financial integration which in turn results in minimum fluctuation in interest rates and safeguard the system from interest rate risks (Liao and Tapsoba, 2014). Conclusion Interest rate risk that arises mainly from the volatility in the interest rates is an inevitable phenomenon in any economy. Many components associated with the banking and financial system such as asset- liability mismatches at the time of maturity and difference between risk free interest rate and real interest rate lead to ignite such risks to a large extent. As the impact of interest rate risk is intensifying and long-enduring, the banking system strongly attempts to minimize the effect of such risk. Considering the approach of Chinese banking system, it is evident that the financial segment of the economy has exercised gap and duration analysis to counter interest rate risk. 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