Interest rate risk in the Indian banking system

Abstract

A strong banking sector is a key to a strong economy and it is in the interest of the banking sector to manage the various risks it faces._ Banks have significant assets in the form of Loans and Advances and Investments and significant liabilities in the form of Deposits and Borrowings. Volatility in the zero coupon values for the yield curve can have significant impact on the assets and liabilities which can impact the equity of the bank._ This project report measures the Interest Rate Exposures using two methodologies using publicly available information in the form of annual reports (Accounting Method) and the stock market prices(Augmented Market Method)._ Banks are required to provide the maturity profiles of its assets(Advances and Investments) and liabilities (Deposits and Borrowings), as mandated by the RBI through its Asset Liability Management guideline._ The accounting method computes the cash flows occurring at different periods and we have used the NSE Zero Coupon Yield Curve for discounting these cash flows. The difference between the cash flows from assets and liabilities gives the impact on the market value of the equity of the bank._ The outcome of the accounting method indicates that a large number of banks are going to be impacted negatively (their equity will go down)with interest rate fluctuations. This exposure has been reducing in the past three years, but still alarmingly high. This has policy level implications for the banks._ The augmented market model measures the relationship between the spread of the short and long bonds with the sensitivity of the stock prices of the banks. The beta value from the regression captures the exposure. The outcome of this model indicates that a large number of banks are carrying significant exposure from interest rate fluctuations._ From a simple correlation analysis, the asset size of the banks has no correlation with the exposure level in the 2006-07 financial year. Neither does the profit after tax have a correlation with the exposures. However there was some correlation in the prior years._ Using similar correlation analysis for the augmented market model, we find that Return on Assets and Capital Adequacy Ratio (CRAR) are negatively correlated with the beta value. However, net NPA ratio is positively correlated with the Beta value.