Banking understanding interest essay

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Banking understanding interest essay

Introduction to Interest Rate Risk: Tillthe regulatory restrictions on banks greatly reduced many of the risks in the financial system. The deposits were taken in at mandatory rates and loaned out at legally established rates. Interest rates therefore remained unaffected by market pressures.

In the 50s and 60s, banks considered only the credit and liquidity risks as major constraints on profitability.

Deregulation of the banking system in the 70s, however, got many bankers unprepared to manage interest rate risk to which their institutions were suddenly exposed. Many bank failures in the world during 70s, 80s and 90s were triggered out of poorly managed interest rate risks.

Many financial institutions funded their long-term fixed assets with short-term volatile liabilities. So long as deposits and lending rates remained regulated, such funding mismatches were not at all a problem. The deregulation of the financial system in India has put in place a lot of operational freedom to the financial institutions and the pricing of various assets and liabilities has been left to their commercial judgement.

The earning of assets and the cost of liabilities are therefore closely related to interest rate volatility. Thus, interest rate risk, a term totally unknown to the banking industry in India has suddenly becomes relevant.

Essentials of Interest Rate Risk: Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value. Market value of an asset or liability is conceptually equal to the present value of current and future cash flows from that asset and liability.

Therefore, the rising interest rate increases the discount rate on those cash flows and decreases the market value of that asset or liability. Conversely falling interest rates increase the market value of assets or liabilities. Moreover, mismatching maturities by holding longer term assets than liabilities means that when interest rates rise, the market value of assets falls by greater amount than liabilities.

This exposes the bank to the risk of economic loss and potentially the risk of insolvency. In other words, interest rate risk arises from holding assets and liabilities with different principal amounts, maturity dates or repricing dates, i.

Accordingly, an effective risk management process that maintains interest rate risk within prudent levels is essential to the safety and soundness of banks. Most of the banks have already identified interest rate risk as a drag on their profitability and have started assessing the magnitude of interest rate risk embedded in their balance sheets.

Interest rate risk is broadly classified into mismatch or gap risk, basis risk, net interest position risk, embedded option risk, yield curve risk, price risk and reinvestment risk.

Sources of Interest Rate Risk: Gap or Mismatch Risk: A gap or mismatch risk arises from holding assets and liabilities with different principal amounts, maturity dates or repricing dates, thereby creating exposure to changes in the level of interest rate.

The gap is the difference between the amount of assets and liabilities on which the interest rates are reset during a given period.

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In other words, when assets and liabilities fall due to repricing in different periods, they can create a mismatch. Such a mismatch or gap may lead to gain or loss depending upon how interest rate in the market tend to move. A bank holds Rs.

However, its profits for second year are not certain. If interest rate remains unchanged, the profits will continue to be the same.

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However, since the liabilities are for one year and need to be rolled over for second year, bank is exposed to interest rate risk. Conversely bank is again exposed to interest rate risk if it holds shorter term assets relative to liabilities, i.

It then faces the uncertainty of interest rate at which it can reinvest funds after the first year for further one year matching the liabilities maturity. Thus, the basis points NII will be preserved.Interest Rate Risk Management | Essay | India | Banking.

Essay on the Controls and Supervision of Interest Rate Risk Management; Essay on the Sound Interest Rate Risk Management Practices If a bank has more assets on which it earns interest than its liabilities on which it pays interest, interest rate risk arises when interest rate.

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Apr 29,  · View and download money and banking essays examples. Also discover topics, titles, outlines, thesis statements, and conclusions for your money and banking essay. If the central bank has an interest rate target, why would an increase in the demand for bank reserves lead to a rise in the money supply?

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Banking understanding interest essay

And if biology is a hard science, it’s on the extreme soft edge of hard sciences.

Economics Essays: Understanding Interest Rates