Banking Risks (Interest Rate Risk, Exchange Risk and Market Risk)

After analyzing the below diagram, Banks are directly affected from three types of Risk namely, Interest Rate

Risk, Exchange Risk & Market Risk which come from three main criteria :-

Government Monetary / Fiscal

/ Industrial Trade Policies

Other Financial Institutions /

Banks lending / Investment

Policies / Dealing / Trading

Corporates Business / Trade /

Market

Interest Rate Risk: - “Risk associated

with the upward and downward of

Interest Rate which directly impact on

the value of Security / Investment /

Profitability /Shareholder Value /

underlying value of Assets & Liabilities,

because the present value of Future Cash Flows change when Interest Rate changes.” Possibility of reduction in

the value of Security / Investment due to change in Interest Rate.

Exchange Risk: - “Exchange Risk is a financial Risk associated with the unanticipated changes in the exchange

rate between two currencies which impact on Security / Investment / Assets / Liabilities hold in foreign

currency.” Foreign Exchange risk arises when a bank holds assets or liabilities in foreign currencies and impacts

the earnings and capital of bank due to the fluctuations in the exchange rates.

Exchange Risk can be either Transactional or it can be Translational.

When the exchange rate changes unfavourably it give rise to Transactional Risk, as the name implies

because of transactions in Foreign Currencies, can be hedged using different techniques.

Other one Translational Risk is an accounting risk arising because of the translation of the assets held

in foreign currency or abroad.

Market Risk: - “It is the Risk of losses in positions arising from unexpected events in the market and

movements in market price”. Risk which is common to an entire class of assets or liabilities. “Bank of

International Settlements (BIS) defines market risk as the risk that the value of 'on' or 'off' balance sheet

positions will be adversely affected by movements in equity and interest rate markets, currency exchange

rates and commodity prices”.

Some Market Risk include: -

Equity risk, the risk that stock or stock indexes (e.g. Euro Stoxx 50, etc. ) prices and/or their implied

volatility will change.

Interest rate risk, the risk that interest rates and /or their implied volatility will change.

Currency risk, the risk that foreign exchange rates and /or their implied volatility will change.

Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil, etc.) and/or their implied

volatility will change.

Implications of upward and downward interest rates on Bank’s Income

“The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term impact of changing interest rates is on the bank’s networth since the economic value of a bank’s assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates.”

The interest rate risk when viewed from these two perspectives is known as ‘earnings perspective’ and ‘economic value’ perspective, respectively.

Management of interest rate risk aims at capturing the risks arising from the maturity and repricing mismatches and is measured both from the earnings and economic value perspective.

Earnings perspective involves analysing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference between the total interest income and the total interest expense.

Economic Value perspective involves analysing the changes of impact of interest on the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off-balance sheet items. It focuses on the risk to networth arising from all repricing mismatches and other interest rate sensitive positions. The economic value perspective identifies risk arising from long-term interest rate gaps.

“After analyzing the table and chart in right side, it is clear that when there is change in the interest rate on

upward direction then Bank Net Interest Income

changes on upward direction, when there is changes

in the interest rate on downward direction then Bank

Net Interest Income changes on downward direction.

So, it clears that changes in Interest rate or Interest

Rate Risk directly hit the earning perspective of the

Bank”.

“After analyzing the table and chart of Net worth Vs

Interest Rate in right side, It is clear that when there is

change in the interest rate on upward direction then

Bank’s Net worth is on downward direction, when

changes in the interest rate on downward direction

then Bank’s Net worth is on upward direction.”

Conclusion: - “After analyzing all the things, it is clear

that Interest Rate Risk directly hit the Bank’s income

on two way basis namely, earning perspective &

Economic Value Perspective”.