Interest rate risk in Indian Banks
By Ila Patnaik (This column appeared in moneycontrol.com 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
adversely.
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
properly.
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
http://www.icrier.org/publications.html.wp
The results of the study clearly suggest that there is a need for
better information, measurement and analysis of bank balance sheets.