Ph.D., assistant prof. Nuzhnova Yuliia, Grygoriev Maksim

National aerospace university named by N. Zhukovskiy “KhAІ”, Ukraine

The problems of interest rate and liquidity risks’ management in banks

The entire human society’s history is marked by the exposure to risks of all kinds and the efforts undergone by humans to deal with the risks. From ancient time, at the emergence of species, the human practiced risk management in order to survive. The practice of survival instincts lead to the avoidance of risks threatening to extinct the human kind. The very existence of human kind today is the proof of the success of applying risk management strategies by our ancestors.

Risks are uncertainties. In the banking universe, there are a large number of risks. As the goal of any privately own company, the main goal of bank’s manage-ment is to maximize the shareholders’ value. Bankruptcies in the financial sector are costly, not only for the equity and debt holders of banks’ but often also for taxpayers. In order to avoid that the banks are constantly under pressure and have to assume high risks and at the same time manage the risks in order to avoid, or at least minimize losses. Competition in the banking sector is typically seen as detrimental to financial stability. The basic idea is that when banks compete intensely for deposits, interest rates fall and their franchise value is eroded. Banks have then less to lose from a default and their incentives to take on risk increase. This argument has been very important in shaping banking regulation around the world, for instance in the form of competition and merger policies.

Banks that manage their risks have a competitive advantage. They take risks consciously, anticipate adverse changes and protect themselves from such changes. As depicted from the figure above the banks have to manage more types of risks in order to maximize the shareholders’ wealth. The most important categories of risks include credit risk, interest rate risk, liquidity risk and operational risk. Credit risk arises when a bank cannot get back the money from loans or investments.

Interest rate risk arises when the market value of a bank asset, loan or security falls when interest rates rise. The solvency of the bank would be threatened when the bank cannot fulfill its promise to pay a fixed amount to depositors because of the decline in the value of the assets caused by increase in interest rate.

Net interest income, the difference between interest income and interest expense, is the main determinant of the profitability of banks. It is determined by interest rates on assets and paid for funds, volume of funds, and as a consequence the changes in interest rate affect the net interest income. Interest rate risk is the potential negative impact on the net interest income and it refers to the vulnerability of an institution’s financial condition to the movement in interest rates. Changes in interest rate affect earnings, value of assets, liability off-balance sheet items and cash flow. Therefore, the objective of interest rate risk management is to maintain earnings, improve the capability, the ability to absorb potential loss and to ensure the adequacy of the compensation received for the risk taken and affect risk return trade-off.

All financial institutions face interest rate risk. Changes in interest rates affect both bank’s earning and expenses and also the economic value of its assets and liabilities. The effects resulting from these changes are reflected in the bank’s capital and income. Bank regulators and supervisors place great emphasis on the evaluation of bank interest rate risk management. These have begun to grow in importance since the implementation of market-risk-based capital charges recommended by the Basel Committee. Interest rate risk management comprises various policies, actions, and techniques that banks use to reduce the risk of reduction of its net equity as a result of adverse changes in interest rates. Complementary with the interest rate risk are among others re-pricing risks, yield curve risk. Any occasion on which interest rates are to be reset, either due to maturities or floating rate resets, is called a re-pricing. The date on which it occurs is called the re-pricing date. Re-pricing risk is when there are fluctuations in interest rates that expose the bank’s income and the underlying value of its instruments to fluctuations, and hence the risk that arises from timing differences in the maturity of fixed rates and the re-pricing of the floating rates of bank assets, liabilities, and off-balance-sheet positions. Re-pricing mismatches expose a bank also to risk deriving from changes in the slope and shape of the yield curve. The yield curve is a graphic representation of the relationship between time to maturity and yield to maturity for a given risk class of securities. It provides a snapshot of the term structure of interest rates in the m arket. The yield to maturity is the average annual rate earned by an investor who holds a security until its maturity. Typically yield curves slope upwards with interest rates rising as the tenor of the security increases. The yield curve shifts with a change in generalized perception about interest rates. The slope of the yield curve tends to be influenced by monetary policy action. Yield curve risk is when yield curve shifts adversely affect a bank’s income or underlying economic value. A rise in interest rates not only triggers an increase in interest earned and paid by the bank, but also a decrease in the market value of fixed-rate assets and liabilities. Usually such a change also causes a decline in demand liabilities and call loans. In effect, when market rates go up, account holders usually find it more convenient to transfer their funds to more profitable types of investment. At the same time, the bank’s debtors (firms or individuals) tend to cut down on the use of credit lines due to the higher cost of these services.

Nonetheless, interest rate risk pertains to all positions in the bank’s assets and liabilities portfolio (namely, the banking book). To measure this risk the bank has to consider all interest-earning and interest-bearing financial instruments and contracts on both sides of the balance sheet, as well as any derivatives whose value depends on market interest rates.

Liquidity risk arises when the bank is unable to meet the demands of depositors and needs of borrowers by turning assets into cash or borrow funds when needed with minimal loss. Liquidity of bank may be defined as the ability to meet anticipated and contingent cash needs. Cash needs arise from withdrawal of deposits, liability maturities and loan disbursals. The requirement for cash is met by increases in deposits and borrowings, loan repayments, investment maturities and the sale of assets. Inadequate liquidity can lead to unexpected cash shortfalls that must be covered at inordinate cost which reduces profitability. It can lead to liquidity insolve-

ncy of the bank without being capital insolvent.

Bank liquidity management policies should comprise a risk management structure, a liquidity management and funding strategy, a set of limits to liquidity risk exposures, and a set of procedures for liquidity planning under alternative scenarios, including crisis situations. Liquidity is necessary for banks to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth. A bank has adequate liquidity potential when it can obtain needed funds promptly and at a reasonable cost. The price of liquidity is a function of market conditions and the market’s perception of the inherent riskiness of the borrowing institution. The importance of liquidity transcends the individual institution, because a liquidity shortfall at a single institution can have system wide repercussions. It is in the nature of a bank to transform the term of its liabilities to different maturities on the asset side of the balance sheet. Liquidity risks are normally managed by a bank’s asset-liability management committee, which must therefore have a thorough understanding of the interrelationship between liquidity and other market and credit risk exposures on the balance sheet.

Forecasting possible future events is an essential part of liquidity planning and risk management. An evaluation of whether or not a bank is sufficiently liquid depends on the behavior of cash flows under different conditions. Liquidity risk management must therefore involve various scenarios. The first scenario, also called “going concern” is ordinarily applied to the management of a bank’s use of deposits. This scenario establishes a benchmark for balance sheet–related cash flows during the normal course of business. The second scenario is related to a bank’s liquidity in a crisis situation, when a significant part of its liabilities cannot be rolled over or replaced. And last but not least, the third scenario is related to general market crises. In this case the liquidity is affected in the entire banking system. Liquidity management under this scenario is predicated on credit quality, with significant differences in funding access existing among banks. The ability to readily convert assets into cash and access to other sources of funding in the event of a liquidity shortage are very important. Diversified liabilities and funding sources usually indicate that a bank has well-developed liquidity management. The level of diversification can be judged according to instrument types, the type of fund provider, and geographical markets.

The essence of risk management is not avoiding or eliminating risk but de-ciding which risks to exploit, which ones to let pass through to investors and which ones to avoid or hedge. Risk management prevents an organization from suffering unacceptable loss that can cause failure or can materially damage its competitive position. Risk management should be a continuous and developing process

which runs throughout the organization’s strategy and the implementation of that strategy. It should address as many of the risks surrounding the organization’s activities past, present and in particular, future, as possible. It cannot be developed a one-size-fit-all risk management process for all the organizations. In the case of a bank, functions of risk management should actually be bank specific dictated by the size and quality of balance sheet, complexity of functions, technical manpower and the status of Management Information System in place in that bank.

Balancing risk and return is not an easy task as risk is subjective and not quantifiable, whereas return is objective and measurable. The extent, to which a bank can take risk more consciously, can anticipate the adverse changes and reacts accordingly, is a determinant of its competitive advantage, as it can as it can offer its products at a better price than its competitors. Because of the fast-changing nature of a bank’s trading book and the complexi-ty of risk management, banks engaged in trading must have market risk measurement and management systems that are conceptually sound and that are implemented with high integrity. This reinforces the fact that risk management structures and related strategies should be embedded in a bank’s culture and not be dependent on just one or two people. Risk management must be integrated into the culture of the organization with an effective policy and a program led by the senior management. It must trans-late the strategy into tactical and operational objectives, assigning responsibility throughout the organization with each manager and employee responsible for the management of risk as part of their job description. The Basel proposals provide a good starting point that banks can use to start building processes and systems attuned to risk management practice.