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Managing Risks in Commercial and Retail Banking by AMALENDU GHOSH

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CHAPTER 18

Interest Rate Risk Management

18.1 INTEREST RATE RISK IN TRADING AND BANKING BOOKS

Interest rate risk refers to the risk of loss of a bank's current and future revenues due from trading and banking book assets and the risk of erosion in the value of those assets on account of movement in the rates. It indicates the extent of sensitivity of a bank to interest rate movements with reference to its current asset-liability position. Interest rate risk causes decline in interest revenues or increase in interest expenses or both simultaneously as well as decline in asset values. Risk encountered from expected changes in interest rates is not really a risk as known risk can be hedged in advance or products can be appropriately priced through inclusion of the risk element. Nonetheless, expected movements of interest rates also generate an element of interest rate risk due to the imperfect competition that usually prevails in the financial market or the asymmetry in interest rate variations on different financial instruments that exists across domestic and international financial markets. Changes in interest rates affect a bank's earnings by changing its net interest income as well as the underlying value of its assets, liabilities, and off-balance-sheet instruments. The short-term impact of changes in interest rates is on earnings, and the long-term impact is on the market value of equity or net worth. Interest rate risk is not a stand-alone risk and is linked to the business ...

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