Question

A commercial bank must demonstrate abilities to manage its credit and interest rate risk to its shareholders and regulators. Describe fully two (2) ways banks can use to analyze and minimize each:

 Credit Risk

 Interest

Answer 1

Ways to analyse and minimize ,

1) Credit Risk

The effective management of credit risk is a critical component of risk management and indispensable for the long-term success of any commercial bank. A variety of approaches can be adopted by a financial institution to mitigate its credit risk. They include, among others,

i. Risk-based pricing: This is a tool which firms use to calculate the interest rates on loans given based on the probability of default, or the risk on the loan.

ii. Covenants: Firms incorporate very strict covenants in their deal contracts. Such covenants generally require the debtor to meet certain conditions such as maintaining a required capital level, or prohibit him from carrying out certain actions.

iii. Credit insurance: Credit insurance covers any losses that may result from unpaid receivables. It also covers bankruptcies as well as late payments.

iv. Credit derivatives: These derivative instruments provide protection against the credit risk of the underlying asset of the derivative.

2) Interest

Interest rates can have adverse effects both on a banking institutions earnings and its economic value.

This has given rise to several perspectives for assessing interest rate risk exposure

1. Earnings Perspective

The focus of analysis is the impact of change in interest rate on accrual or reported earnings. This is the

traditional approach. Reduced earnings or outright losses can threaten the financial stability of an institution by

undermining its capital adequacy and reducing market confidence.

The component of earnings that has traditionally received the most attention is net interest income

(Interest Income-Interest exposure). The percentage net interest income to the total income of the bank, would

suggest the extend of the exposure to interest rate risk.

2. Economic Value Perspective

Variation in market interest rates can also affect the economic value of a banking institution‟s assets, liabilities

and OBS positions. The economic value of an instrument represents an assessment of the present value of its

expected net cash flows, discounted to reflect market rates.

The economic value perspective reflects one view of the sensitivity of the net worth of the banking

institution to fluctuations in interest rates. Since the economic value perspective considers the potential impact

of interest rate changes on the present value of all future cash flows, it provides a more comprehensive view of

the potential long term effects of changes in interest rates than offered by the earnings perspective.

Measurement Techniques :

1. Gap Analysis

The simplest technique for measuring interest rate risk exposure begins with a maturity/re-pricing

schedule that distributes interest-sensitive assets, liabilities and OBS positions into time bands according to their

maturity (if fixed rate) or time remaining to their next re-pricing (if floating rate)

The schedule can be used to generate simple indicators of the interest rate risk sensitivity of both

earnings and economic value to changing interest rates. When this approach is used to assess the interest rate

risk of current earnings, it is typically referred to as Gap Analysis. The size of the gap for a given time band

gives an indication of the banking institutions re-pricing risk exposure.

2. Duration

This is a measure of the percentage change in the economic value of a position that will occur given a

small change in the level of interest rates. A maturity/repricing schedule can be used to evaluate the effect of

changing interest rates on a banking institutions economic value by applying sensitivity weights to each time

band. Typically such weights are based on estimates of the duration of the assets and liabilities that fall into

each time-band. Duration-based weights can be used in combination with a maturity/repricing schedule to

provide a rough approximation of the change in banking institutions economic value that would occur given a

particular set of changes in market interest rates.