Interest rate risk in Indian Banks

By Ila Patnaik (This column appeared in in January 2003)

The sharp decline in interest rates on government bonds in the last

couple of years has lead to a huge increase in profits of many

banks. In 2001-02 the net profits of scheduled commercial banks

increased by 81 per cent over the previous year. The numbers for

2002-03 are likely to be equally high, if not higher.

If two years ago one looked at the situation very cursorily it might

have appeared that banks would lose if interest rates go down. In

fact, about a year ago a lot of banks appeared to be worried about

cuts in the bank rate by the RBI. They seemed to think that this would

lead to a reduction in their interest income from loans while the

interest they pay out on deposits would not reduce correspondingly,

because of factors such as the fixed savings account rate and the

general downward inflexibility of deposit rates. This, they felt,

would reduce their net interest income and affect their profits


This perception turned out to be wrong mainly because banks and

analysts were then not able to fully comprehend the extent of the

impact of interest rate movements on the value of their large holdings

of government bonds. This is not surprising because the regime of

volatile interest rates and especially downward movement in interest

rates is relatively new in India. It is only after 1993 that interest

rates were allowed to be market determined.

Though rates have declined sharply, it is not possible that they will

keep on falling forever. The question today is : What will happen if

interest rates were to start going up? How will bank balance sheets be

affected? What would be the impact on bank equity in such an event?

Let us imagine a bank that has Rs 10 of equity. It borrows Rs 90. Let

Rs 40 be demand deposits while Rs 50 are time deposits. Say time

deposits have an average maturity of 2 years which is offset by loans

of this maturity. So on the asset side of the bank are Rs 50 of loans

and Rs 40 of Government of India bonds which the bank holds partly as

SLR requirement and partly because it is unwilling or unable to lend

in the market.

The maturity of the bonds being held by the bank determine the impact

of interest rate changes on the value of its bond holdings. Bonds with

long maturities have a steeper price-yield curve than bonds with

shorter maturities. Thus maturity itself is not adequate to tell us

the interest rate senstivity of a bond price. To examine the impact

of interest rate movements we define 'duration' which takes into

account the times payments are made. If a bonds has a duration of 10

years a one percent change in the interest rate changes the bond price

by 10 percent.

In our bank suppose the average duration is 10 years and there is

a 100 bps increase in interest rate then the value of bond holdings of

the bank decline by 10 per cent of Rs 40 or Rs 4. If these are

unhedged by changes in the value of liabilities then this constitutes

a hit to equity capital of 40 per cent.

Banks in India, especially a number of public sector banks, hold GOI

bonds of long duration. The focus of both the stock market and

regulation has until now been on credit risk and the significant

interest rate risk exposure of banks is not always being assessed


In a recent study, Ajay Shah of the Ministry of Finance and I have

tried to measure interest rate risk of Indian banks. Examining

accounting data showing maturities of assets and liabilities of banks

(as presented in the annual report of banks) we find that in a sample

of 42 banks at least 25 stand to lose more than 25 per cent of their

equity when interest rates move by 320 bps. These include banks such

as Dena Bank that stands to lose 96 per cent of its equity in such an

event, Vijaya Bank that stands to lose 80 per cent and Bank of Baroda

that stands to lose 41 per cent of equity.

Is the stock market taking adequate notice of this? While for some

banks the stock market seems to be in tune with the accounting data

assessment of interest rate risk, in other cases, the interest

senstivity of bank stock market prices to changes in interest rates is

very low. So, for instance, for Vijaya Bank and the Bank of Baroda the

stock market sees significant sensitivity of stock prices to interest

rates, while for Dena Bank it does not. Interestingly, while

accounting data for UTI shows no significant interest rate risk

exposure, the stock market believes that the exposure is

significant. A paper based on the study is available at

The results of the study clearly suggest that there is a need for

better information, measurement and analysis of bank balance sheets.

Ila Patnaik