Interest Rate Risk: Using Derivatives in Banking

April 25, 2020

Interest Rate Risk: Potential of Using Derivatives in Banking in Bangladesh

(Published in the Financial Express in 2018)

Dr. Shah Md Ahsan Habib[1]

Banks in Bangladesh generally follows fixed interest rates in their lending and borrowing operations. Asset portfolios of banks commonly have considerable volume of long-term assets, whereas the liability side heavily depends upon core and short term deposits that are exposed to the movements of interest rates. However, banks in the country generally follow a process of adjustment in the deposit and lending rates with the changing market interest rates, though not in all instances. In the absence of a unitary benchmark interest rate, there are only a few instances of variable interest tagged loan products. Practically, the bank based small financial sector of the country is yet to enforce truly market based interest rate practices which is essential for identifying a benchmark rates.

As a whole the structure may be termed as segmented interest rate. In case of deposit, rates are always fixed in nature as the depositors do not like the uncertainty in case of expected future return. But the tenure of most of the deposits mobilized by the bank is short (usually less than one year). When a deposit scheme matures, it is renewed at the rate of that time. As such most of the deposits are subject to re-pricing within one year. This actually makes the deposit products of a bank rate sensitive although they are priced with a fixed rate. Only a small portion of deposits of a bank are fixed rate liability.

A contrasting picture may be observed in case of lending where a significant portion of loan is given for more than one year. So the pricing is a crucial issue for lending as it involves interest rate risk. Usually floating rate is observed in many countries while determining the lending rate which actually minimizes the interest rate risk. But true floating rate is almost nonexistent in the banking sector of Bangladesh. Banks usually offer fixed rate to the borrower but a condition is imposed on the lending rate which clearly stated that rates are subject to change. By putting this condition banks can change the lending rate whenever it deemed necessary. Although most of the lending rate seems fixed actually they are floating in nature. This technique is applied by the Bangladeshi banking system to minimize the interest rate risk in most of the cases.

Like other countries, these rates are not tagged with the market driven interest rate such as LIBOR or any government securities. In the country, generally treasury department of a bank practices different techniques such as ‘rate sensitive gap analysis’ or ‘duration gap analysis’ or ‘fund transfer pricing analysis’ for measuring the effect of interest rate risk, as identified in the process of discussion with treasury heads. Most of the treasury departments of the banks of Bangladesh use above- mentioned techniques to measure the impact of fluctuating interest rate in its net income and equity position. Among these techniques rate sensitive gap analysis or duration gap analysis are very popular and widely used by the banks. Fund transfer pricing, though very important, are yet get due importance because if it’s technical difficulties. It is important to note that the result of these types of analysis will be beneficial for a bank to minimize interest rate risk only if due market environment and appropriate risk management products are available in the market. There are only a few instances of interest rate derivative deals, and Bangladesh is yet to draw true benefits of derivative products.

There are also instances, although very few, that some borrower were successful in locking their borrowed fund at fixed rate when lending rate was very low. In this case banks are exposed to interest rate risk which needs to be mitigated. It is also observed that in some cases banks offer floating interest rate loan to the borrower. In this case the lending rate is tagged with the government securities to make it adjustable with time. Such technique helps bank to reduce interest rate risk as the government securities are used as a benchmark rate.

The derivative market in Bangladesh is very shallow. Foreign exchange derivatives like Forward and SWAP are available in the market like most of the other developing countries. Most of the banks use these products to minimize their forex risk exposure. There was a guideline in regards to commodity derivative and only a few transaction has happened so far under commodity derivative. But interest rate derivative is almost nonexistent. Bangladesh Bank has given the regulatory guideline on both forex and interest rate derivative products in its Foreign Exchange Risk Management Guideline.  BSEC has also mentioned about derivatives in its directives issued in 2016. The interest rate derivative products are not generally allowed, although the BB guideline provides instruction about the mechanism of interest rate derivative products. Bangladesh Bank allowed these products subject to the case to case approval basis.

Currently, the banking sector of the country are engaged in transacting foreign exchange forward and swap transactions in addressing exchange rate risks at limited scale. Though, commodity derivatives were allowed in 2007 to address price risk exposures of traders, in the absence of basic cash commodity exchanges only a few deals were executed with the case-to-case permission from the central bank. The most recent Foreign Exchange Risk Management Guideline of Bangladesh Bank explicitly mentioned the permissible nature of interest rate derivatives in foreign currencies, and a few transactions were permitted. The existing foreign currency borrowings of local corporates is offering avenues to undertake interest rate swap transactions to address the potential trend of growing LIBOR in near future. Bangladesh Bank may think of offering more permission to undertake interest rate swap to address the potential volatile scenario of LIBOR. 

Available evidences reveal that the financial and banking market of the country lacks several pre-requisites associated with regulatory, macro, and market developments to initiate such financial engineering products in the country.  However, for obtaining greater benefits and for ensuring improved growth supports, the country cannot keep away itself from the initiatives of bond, insurance, commodity, and equity market developments and thus from derivatives for effective risk management. A good number of countries including the neighboring India have already moved much ahead in the process where the foundation was created through introducing interest rate OTC derivatives, and later exchange traded tools.  To draw future path, the policy and strategic documents include development of local currency OTC derivatives in the market development targets and work plan.

[1] Professor and Director (Training), BIBM ([email protected]).

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