Minimizing Interest Rate Risk in Banking

April 25, 2020

Measuring and Minimizing Interest Rate Risk in Banking

(Published in the Financial Express in 2018)

Dr. Shah Md Ahsan Habib[1]

Apart from traditional ways to measure and manage interest rate risk, derivatives are in use by banks and financial institutions. In another way, risk can be managed on-balance sheet with debt capacity and payout flexibility and off-balance sheet, with derivative contracts. Banks participate in derivative markets especially because their traditional lending and borrowing activities expose them to financial market risk and doing so can help them to hedge or reduce risk and to achieve acceptable financial performance. Corporates or borrower may have specific objectives when choosing a hedging strategy. The goal may be to lock in a fixed interest rate, taking advantage of a favorable environment and removing interest rate risk as a consideration; to more effectively match interest rate sensitive assets and liabilities; to better diversify financial risks in a loan portfolio. Interest rate derivatives enable commercial banks to shield their lending policy against interest rate shocks, to better exploit lending opportunities arising from real shocks and to smooth dividend distributions. However, a note of caution is that the use of derivatives can both increase or reduce the occurrence of bank defaults, while exacerbating or mitigating the agency conflict between debt and equity claimants; this is because derivatives can be optimally used to achieve transfers between states that are less associated with default to states that are more associated with default, or the contrary.

Derivatives can either be traded on organized exchanges or negotiated privately between two parties like banks and corporates. Over-the-counter or OTC trades, allow parties to customize features of the derivative to serve the specific needs of the users. Trading on OTC interest rate derivatives market is a common think for the European developed countries, as well as for United States. The interest rate contracts are today the largest segment in the global OTC derivatives market. The interest rate derivatives are less transacted in emerging markets than those based in the largest, well known derivatives markets. Derivatives activities realized by dealers based in emerging countries focus mainly on the foreign exchange rate risk and less on interest rate risk. Although significantly increased in the last decade (mainly in Asia), interest rate derivatives markets in developing countries are still in nascent stage. Some developing countries have undertaken a series of reforms to deepen the local bond market and create the necessary preconditions for the development of derivatives markets. In most developing countries still the main problem for the interest rate derivatives development is the lack of basic conditions, including inadequate measurement of interest rate risk exposure, underdevelopment of financial markets in general and especially of market instruments that underlying derivatives, weak and/or inadequate infrastructure and legal framework, misunderstanding and lack of experience in operations with financial derivatives and the complexity of the derivatives accounting.

Equity derivatives, interest rate derivatives, commodity derivatives, foreign exchange derivatives, and credit derivatives are the derivative products available all over the world. From all types of derivatives, interest rate derivative is regarded as the most popular product and interest rate derivative market is the largest derivative market in World. There are two ways to trade these derivative products, one is through Over the Counter (OTC) derivative market and another is through recognized exchanges. In OTC, market contracts are bilateral, and each party could have credit risk concerns with respect to the other party. The OTC derivative market is significant in some asset classes: interest rate, foreign exchange, stocks, and commodities that  allow parties to customize features to serve the specific needs of the users. The development of the interest rate derivatives has its roots in the mid-1970s that passed through constant modification and development. Formal OTC interest rate hedging came into focus in early 1980s when IBM and the World Bank made the first formalized swap, a currency transaction. The interest rate swap is basically a succession to the currency swap, and the currency swap was a successor to the back-to-back loan. Back-to back loans were developed when exchange, controls were in force in the United Kingdom in the 1970s which in effect limited the access of residents and non-residents to each other’s capital markets. The evolution of Forward Rate Agreement from the perspective of the currency in which they are denominated shows that the trend is almost the same as in the case of the evolution of the global OTC interest rate derivatives market. Since introduction in the early 1980s, interest rate swaps have become one of the most powerful and popular risk-management tools for banks and business corporations. Banks, functioning as financial intermediaries, are natural users of interest rate swaps. They use swaps to hedge interest rate risk in their business operations and to meet the demands for swap transactions from their clients. Banks have emerged as the major players in the market for interest rate swaps.

Both investment banks and commercial banks have been active in arranging interest rate swaps. They earn fees by bringing the different parties together and by acting as settlement agents. Settlement agents collect and pay the net difference in the interest payments and serve as guarantor of the agreement. Most intermediaries have gone beyond their initial role of merely bringing different parties together by actually functioning as dealers. In other words, each party has an agreement only with the intermediary and is totally unaware of who might be on the other side of the swap. The intermediary actually sells one party a swap without having the opposite swap with someone else at that particular time. It holds the swap in inventory in hope that another firm will later want a swap with the opposite position. This arrangement has facilitated the development of a secondary market in swaps, thereby increasing the liquidity of this instrument. The development of a secondary market, in turn, began to allow for the reversing, terminating, and general selling of existing swaps.  Other variations on swaps began to develop at approximately the same time such as variable/variable rate swaps based on different indexes.

Corporates may obtain Benefits by using OTC derivatives offered by banks. Interest rate risk can be problematic for a corporates for several reasons: companies with floating or variable rate debt outstanding are exposed to increases in interest rates, whereas companies with borrowing costs which are totally or partly fixed will be exposed to falls in interest rates. The reverse is true for companies with cash term deposits.  Recently publicly funded universities have started using interest rate swaps, as the public funding proportion of the university funding started shrinking over the past decade, universities have resorted to commercial borrowing for construction and renovation of residences and other buildings. Available published report indicates that most universities in Canada actually designate the swap as a hedging instrument to manage interest rate risk.

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

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