Viral V Acharya: Understanding and managing interest rate risk at
banks
Speech by Dr Viral V Acharya, Deputy Governor of the Reserve Bank of India, at the Fixed
Income Money Markets and Derivatives Association (FIIMDA) Annual Dinner, Mumbai, 15 January
2018.
* * *
Let me at the outset wish all of you a happy and healthy New Year.
Thank you to Fixed Income Money Markets and Derivatives Association (FIIMDA) and its
organizing team for inviting me to deliver this keynote address at its Annual Meet. I will speak
today about understanding and managing better the interest rate risk at Indian banks. I will start,
however, by looking elsewhere and historically, often a very good place to start.
In the period after the Global Financial Crisis, bank exposures to sovereign debt have increased
significantly in many economies, including advanced ones, deepening the linkage of bank
balance sheets with sovereign debt. Several important drivers are deemed to be at work behind
this phenomenon:
1. Exceptionally accommodative monetary policy in advanced economies, coupled with a
general post-crisis fall in the risk appetite of global investors, created a natural demand to
hold sovereign debt of safe-haven economies.
2. Under Basel capital regulations for banks, sovereign bond exposures continue to attract 0%
risk weight in home countries and some currency unions, besides not being subject to
concentration limits. This makes sovereign bonds a more attractive investment for banks
vis-a-vis other assets of similar riskiness. Liquidity of sovereign bonds as well as such
securities being eligible collateral for refinance by central banks only further adds to their
attractiveness.
3. Liquidity Coverage Ratio (LCR) regulation (under Basel-III) also requires banks to hold High
Quality Liquid Assets (HQLA). Though there are other securities eligible as HQLA, the cost
and ease of holding are the most attractive for sovereign bonds.
While sovereign bonds may be safer and more liquid than other instruments at a given point of
time, there is no guarantee that they will remain so as both credit risk and liquidity risk of
sovereign debt are dynamic in nature, and in fact, can shift deceptively so as these risks
materialize from seemingly calm initial states.
Sovereign debt-bank nexus and Eurozone sovereign debt crisis
The potential negative impact of sovereign debt-bank nexus and the need for addressing it has
attracted much international attention, particularly in Europe. Exposures of resident banks to
domestic sovereign debts in countries that faced debt crisis (Greece, Italy, Ireland, Portugal, and
Spain, or GIIPS) increased significantly during and after the crisis. Moreover, the increased
exposure of banks to sovereign debts exhibited a domestic bias in case of the riskier sovereigns,
i.e., the GIIPS, with share of resident banks increasing while that of non-residents declining; the
holdings of resident banks continue to be at a high level (Chart 1).
The large holdings of domestic sovereign debt by banks played a key role in exacerbating the
sovereign debt crisis in peripheral European countries. From January 2007 until the first bank
bailout announcement in late September 2008, there was a sustained rise in bank credit spreads
while sovereign credit spreads remained low. During September-October 2008, bank bailouts
became a pervasive feature across developed economies and there was a significant decline in
bank credit spreads with a corresponding increase in sovereign credit spreads. In effect, bank
bailouts transferred credit risk from the financial sector to the sovereigns (Acharya, Drechsler
and Schnabl, 2012; 2015). However, and especially post the Greek default in 2010, sovereign
spreads in the GIIPS widened too over the German Bunds due to macroeconomic concerns in
the European periphery, causing significant valuation losses for banks and casting doubt on their
solvency.
Concomitantly, rising yields on sovereign bonds enticed banks to stock up on their domestic
sovereign exposures. With continuing access to short-term funding, notably in deposit and
money markets, banks in GIIPS and even some non-GIIPS countries increased investments in
GIIPS sovereign bonds so as to purchase "carry" over the German Bunds, hoping for future
convergence of yield (Acharya and Steffen, 2015). This "carry trade" was particularly attractive
for under-capitalized banks as a way to gamble for resurrection, effectively chasing quick
Treasury gains with no additional capital requirement, but doubling up on economic risks if the
carry were to widen even further... and it did. The Greek default and ensuing sovereign debt
crises in the GIIPS countries showed that banks having significant exposures to sovereign debt
were the most susceptible to fluctuations in sovereign borrowing costs and faced attendant
market plus funding consequences.
Such sovereign debt-bank nexus creates a two-way feedback loop. As banks are highly exposed
to the domestic sovereign, any adverse movement in yields or materialisation of a sovereign
event could trigger bank under-capitalization and bailouts, which imply further sovereign
borrowing and rising sovereign yields, leading to further erosion of bank capital and need for
further bailouts, and so on (Acharya, Drechsler and Schnabl, 2012; 2015).
Understanding and managing well the banking sector's exposure to risks embedded in domestic
sovereign debt is thus not just a matter of banking sector's profits and capital, but in fact it is one
of overall macroeconomic stability.
The Indian context
In India, the linkage between sovereign debt and bank balance sheets has always been strong
given the Statutory Liquidity Ratio (SLR) prescriptions for banks and the historical role that banks
have played in supporting public debt. Banks, under section 42 of the Reserve Bank of India Act,
1934, are required to maintain minimum liquid assets (basically Government securities - both
Central Government securities or G-Secs, and sub-sovereign securities called State
Development Loans (SDLs)) as a percentage of Demand and Time Liabilities (DTL). This ratio
has historically been as high as 38.5%, but has gradually come down to 19.5% now (Chart 2),
being brought steadily in line with international levels of the Liquidity Coverage Ratio (LCR) under
Basel-III.
The resulting large holding of G-Secs and SDLs by banks exposes them to re-pricing of
governments' borrowing costs which could rise due to inflationary, fiscal or other domestic as
well as global macroeconomic developments. I propose to (i) draw attention to the significance of
this interest rate risk exposure of Indian banks; (ii) urge banks to pay greater attention and devote
more resources to their Treasury operations; and, (iii) lay out some options available to banks for
managing the risk efficiently.
Understanding interest rate risk at banks
Let us start by first principles. Interest rate risk is most simply understood by looking at the
(approximate) price equation for a bond portfolio when there is a (small) change in the underlying
interest rates, such as the level of government's borrowing cost:
∆P = - P × D × ∆Y, where
∆ denotes change; P denotes the portfolio's market value;
D denotes the "duration", a measure of the interest rate sensitivity of the portfolio;
and,Y denotes an underlying interest rate (or portfolio yield).
In other words, the value of the investment portfolio is a function of three factors:
1. The size of the portfolio denoted by P ;
2. The duration denoted by D, which roughly captures the weighted average maturity of cash-
flows of bonds in the portfolio; and,
3. The increase in yields denoted by ∆Y.
For example, a portfolio of size 1 trillion with 10 years of duration, falls in value by 10 billion upon
a 0.1% or 10 basis points (bps) rise in the 10-year G-Sec benchmark yield.
Let us consider each of these factors, in turn, in the present and historical Indian context.
1
Size of the portfolio
The share of commercial banks in outstanding G-Secs is around 40% (June 2017). Investment
of Scheduled Commercial Banks (SCBs) in G-Secs as a percentage of their total investment
was around 82% for FY 2016-17. The corresponding figure for Public Sector Banks (PSBs) for
FY 2016-17 is slightly higher at 84%. This exposure has noticeably increased since 2014 (Chart
3a).
In spite of the relative stability of the consolidated Debt/GDP ratio of the government, the investor
base for G-Secs in India is primarily limited to domestic institutions. As a result, there are often
situations of oversupply of government bonds relative to demand. This appears to be the case
especially for Indian banks going by their high excess SLR holdings. One reason banks end up
holding high levels of government debt is because in the Indian milieu, they end up as residual
holders in case of relative oversupply, as the appetite of other major institutional investor
categories like insurance and pension funds is limited by their investment mandates. Another
important reason in recent times has been that excess liquidity in the banking system did not end
up being parked at the Reserve Bank's liquidity mop-up operations which would have kept
duration risk minimal. Instead, the surplus liquidity found its way into G-Secs as domestic
sovereign debt is the most attractive investment for capital-starved banks looking for short-term
gains even if at the expense of greater duration (as I explained earlier, this was the case also in
the European context).
As a result, the size of banking sector's balance-sheet exposure to G-Secs, and hence, its
interest rate risk, is high in an absolute sense, and is relatively elevated, when measured in
proportion to total assets, for public sector banks relative to private banks (Chart 3b).
Duration of investment book and the maturity structure of G-Secs
The high interest rate exposure of banks from their G-Sec portfolios is attributable to not only the
size of their holdings, but also to the increasing maturity of primary issuance. The weighted
average maturity of the stock of Government securities has increased steadily from 9.66 yrs in
2012-13 to 10.67 yrs in 2017-18 (Chart 4). The average tenor of annual issuance during the last
five years has been high at around 15 years.
What are implications of this changing maturity structure of G-Secs for the duration of bank
investment portfolios?
The investment portfolio of banks is classified under three categories, viz., 'Held to Maturity
(HTM)', 'Available for Sale (AFS)' and 'Held for Trading (HFT)'. Banks normally hold securities
acquired by them with the intention to hold them up to maturity under HTM category. Only debt
securities are permitted to be held under HTM with a few exceptions, e.g., equity held in
subsidiaries. Holding securities under HTM provides cushion for banks from valuation changes.
However, holding in HTM book is subjected to a ceiling.
AFS and HFT categories together form the trading book of banks. Banks are permitted to decide
on the extent of holdings under AFS and HFT based on their trading strategy, risk appetite, capital
position, etc. Securities held under both these books are required to be marked to market. HFT
book is required to be marked to market on a more frequent basis than AFS. Valuation frequency
of investment is typically a determinant in the composition of investment book of banks.
Correspondingly, shares of HTM, AFS and HFT are 55.4%, 42.5% and 2.1%, respectively, as on
September 2017 (Financial Stability Report, RBI, December 2017). The average modified
duration of the AFS book of banks is currently around 2.9 years. The comparable figure for PSBs
is higher at 3.5 years and for PvtSBs is at 2.0 years.
With relatively high duration and concentration of G-Secs in investment portfolio, bank earnings
and capital remain exposed to adverse yield moves, especially as the share of investment
income has been on the rise in the last five years. Chart 5 captures this fact succinctly that
investment income of banks is highly sensitive to G-Sec yields - yields had by and large fallen in
recent years, and consequently, investment income went up. In turn, and given the muted credit
growth over this period, especially at PSBs, investment income has again started playing a
rather important role in determining bank earnings.
Movement in yields - Phases of sustained yield rise
G-Sec yields in India have undergone episodic phases of sustained rise of close to 200 bps at
regular intervals. Chart 6 identifies three major phases for the 10-year benchmark yield over the
past 15 years:
1. Phase I - second half of 2004 when interest rate cycle turned up from 5.00% to over 7.00%,
following a prolonged rally;
2. Phase II - post the global financial crisis when yields rose from around 5.25% in December
2008 to around 8.80% by November 2011; and,
3. Phase III - during the taper tantrum episode when yields rose from around 7.25% at end-May
2013 to just below 9% by end-December 2013;
My point in showing this time-series and episodic phases of G-Sec yield movements is that
banks should not be surprised repeatedly when government bond yields rise sharply and their
investment profits drop. RBI's Financial Stability Reports (FSR) have regularly pointed out the
impact of such large interest rate moves on capital and profitability of banks. Banks should know
and understand this risk rather well. Perhaps they do, and the issue is really one of incentives
that lead to their ignoring this risk, which I will turn to next.
Heads I win, tails the regulator dispenses
How have these episodic phases of sustained rise in G-Sec yield played out?
During Phase I, responding to the clamour for regulatory forbearance, banks were permitted to
hold G-Secs up to the mandated Statutory Liquidity Ratio (SLR) of 25% of Demand and Time
Liabilities (DTL) under the Held to Maturity (HTM) accounting category. Regulation also enabled
banks to shift securities from other accounting categories into the HTM category, as a one-time
measure, a feature that has now acquired an annual dimension.
A similar one-time transfer was extended during Phase III, in addition to deferment in recognition
of valuation losses by six months, from September 2013 to March 2014.
The impact of the persistent rise in yields during Phase II was eased to a great degree by regular
open market purchases by RBI, which are typically employed for durable liquidity management
and to ensure the proximity of money market rates to the overnight policy rate, rather than for
management of long-term G-Sec yields.
These are also the sort of measures some banks have again requested RBI to adopt in the
current phase of rising yields, wherein yields have moved up from around 6.50% at end-August
2017 to around 7.45% now.
Interest rate risk of banks cannot be managed over and over again by their regulator. The
regulator, in interest of financial stability, is caught in such situations between a rock and a hard
place, and often obliges. However, the trend of regular use of ex post regulatory dispensation to
ease the interest rate risk of banks is not desirable from the point of view of efficient price
discovery in the G-Sec market and effective market discipline on the G-Sec issuer. Nor does it
augur well for developing a sound risk management culture at banks. Recourse to such
asymmetric options - heads I win, tails the regulator dispenses - is akin to the use of steroids.
They get addictive and have long-term adverse effects in the form of frequent relapse even
though their use may be justified to relieve occasional intense pain. Hence, it would be better for
the banking system to build its own immunity and strength, i.e., emphasise internally - and put in
2
place processes for - efficient management of interest-rate risk.
Let me then discuss what could be done by banks to achieve this.
Managing interest rate risk at banks
Management of the increasing interest rate exposure of the banking system needs to address
both sides of the sovereign-bank nexus. While the long-term investor participation in government
bond market needs to be deepened - both domestically and internationally, and the maturity
structure of government debt kept sensitive to implications for bank balance-sheets, banks also
need to manage the interest rate risk on the balance sheet by dynamically managing its size and
duration as well as accessing markets for risk transfer.
The desirable options follow from the bond price equation I presented earlier:
∆P = - P × D × ∆Y.
Interest rate risk management options can thus be categorised as follows:
1. Measures that address P, viz., the G-Sec portfolio size of banks;
2. Measures that address D, viz., the duration risk; and,
3. Measures that address the valuation impact in scenarios with potentially large changes in
yield.
Measures that address the G-Sec portfolio size of banks
The size of the G-Sec portfolio of banks is mainly a function of balance sheet choices made by
banks among competing assets. Recognizing at the outset that G-Sec portfolio is subject to
interest rate risk, a risk-management strategy can be put in place along the following lines:
1. The bank's Board in discussions with the Treasury head and Chief Risk Officer (CRO) can
approve the risk limit for the portfolio in terms of the capital that can be put at risk. This
assigned risk capital, much like a corporate budget, should transform into a risk strategy and
be guarded in a manner that adjusts for changing risks rather than merely serving as an
easy-to-game compliance limit.
2. The assigned risk capital should not get wiped out under reasonable stress scenarios,
which can be modelled as high confidence level tail events for bond yields under value at
risk or expected loss approach. In other words, banks should not lose capital allocated to
the Treasury function other than with an extremely small likelihood.
3. Given the non-linearity in yield movements (the risk that risk will change, or in other words,
yield volatility being stochastic), as manifested in the episodic volatility phases I showed,
banks should also factor in historical stress scenarios. Under these historical stress tests
as well, capital allocated to the Treasury function should not get wiped out.
4. In addition, banks should conduct reverse stress tests, i.e., ask the question as to what kind
of G-Sec yield movements, parallel shift at a minimum but ideally also yield-curve
steepening, would wipe out the allocated capital? Indeed, such reverse stress tests have
been recommended by the Reserve Bank and could become part of Board-level risk
discussions.
5. However, no stress test is perfect; and, no risk measure such as value at risk or expected
losses which use historical distributions can anticipate fully the nature of future yield
movements. Hence, banks also need to adopt robust risk controls for resilience. This can
involve concentration limits, so banks do not exceed their exposure to G-Secs beyond an
internally agreed total proportion of assets; or the excess SLR should be commensurate in
risk terms with the bank's capital allocation for investments.
6. In order to further address Treasury-level incentive issues, banks may consider imposing
dynamic stop loss limits. In order to avoid further losses once they exceed a particular
percentage of assigned risk capital, any risk addition must slow down, potentially even stop
(depending on the extent of realized capital loss), and not be gerrymandered through
security rotation or by senior management turning a blind eye. Instead, the realised losses
and residual risks should escalate through CRO to the bank Board and the risk in the
investment portfolio gradually scaled down in a time-bound manner depending on its size.
7. In addition, there should be ex-post settling up as a career incentive for the Treasury head
and all significant risk-takers: those who swing bank investment portfolio for the fences and
put bank capital at excessive limits relative to the approved levels should be held
accountable when their bets go bad due to poor or no risk management. Not all volatility is
due to "black swan" events that deserve risk-takers being carried through.
8. Finally, there is usually an uninspiring chatter every time G-Sec yields show a sustained rise
that the market is irrational in its movements. Not only is it not difficult to separate rational
market movements from irrational ones at high frequency, such proclamations are a sign
that those betting on government bonds while chatting such are clueless about the drivers of
market movements. Isn't that a good time for the bank senior management to rein in their
Treasury portfolio risks?
None of this is rocket science but does require at the highest level of bank governance
mechanisms a recognition of interest rate risk, an incentive to manage it, and a top-down
organizational strategy to implement it.
Measures that address the duration risk of banks
How may banks better manage their duration risk?
The efficiency with which this risk is currently managed leaves a lot to be desired. While duration
risk management is constrained by the G-Secs issuer's choice of maturity structure and liquidity
in the secondary bond market, the risk can be managed more nimbly by also availing of hedging
markets. PSBs account for about 70.6% of the banking sector assets. However, their
participation in such hedging markets is limited or negligible. While their share in secondary
market trading of G-Secs is about 33%, their share in hedging activity in the Interest Rate Swap
(IRS) and Interest Rate Future (IRF) segments is only 4.61% and 13.40%, respectively.
Let me elaborate. RBI introduced Rupee interest rate derivatives in the OTC market, viz., Interest
Rate Swaps (IRS) and Forward Rate Agreement (FRA), in 1999. Interest Rate Futures (IRFs)
were first introduced in the Indian markets in 2003 but only the current bond future contract,
introduced in 2014, has seen reasonable activity. Liquidity in the interest rate products has
generally been low. The open interest and daily volume in the interest rate futures market are
usually between Rs.20-30 billion while the daily volume in the Overnight Indexed Swap (OIS)
interest rate swap market is around Rs.150 billion. Besides, only a section of the banks are
active in the OIS market. Compared to an average daily bond market volume of Rs.400-500
billion, interest rate derivative markets are thus rather thin.
Wider participation by banks in interest rate derivative markets - both futures and swaps - is
necessary for improving liquidity in these markets, which is necessary for banks to off-load their
significant duration risk onto others. As more hedgers access these markets, there would be
incentives for market makers to allocate more capital to these activities, kicking off a virtuous
cycle of interest rate risk-sharing and leading over time to a more vibrant derivative market.
In other words, the Treasury functions at banks need to be modernized with urgency, subjected
to careful scrutiny by Boards, overlaid with prudent risk management practices, and trained to
employ hedging instruments specifically targeted at managing interest rate risk.
This takes me to the important issue of how banks should manage large changes in yields.
Measures that manage the impact of potentially large changes in yield
Given the nascent stage of our interest rate derivative markets, banks need to manage
exposures to large changes in yield with a multitude of instruments and trading platforms. All
options should be on the table. An oft-cited reason for the lack of such comprehensive risk
management by banks is that hedging markets that can enable neutralization of large changes in
yield lack the size or depth or liquidity to meet the needs of large banks. True as this argument is
at some level, it is the very lack of participation by large banks that makes these markets illiquid
and small. RBI systematically engages with the market to take necessary steps to create an
enabling environment for markets to develop - creating trading, settlement and reporting
infrastructure; introducing products; easing processes; etc.
India's G-Sec market infrastructure is arguably the best in the world. We have enabled
guaranteed settlement in G-Secs, forex and interest rate swaps. Despite the existence of the
facility to short sell and availability of futures and swap markets, it appears that for most banks
investment activity essentially consists of two steps - buying and hoping for the best. But hope
should not be a Treasury desk's primary trading strategy.
RBI has also permitted money market futures about a year back. Those directions were a
significant deviation from the earlier prescriptive approach. Exchanges were given complete
freedom to design and introduce products. We are yet to receive any proposal for approval.
Similarly, interest rate options were also permitted sometime back, but market has still not kicked
off. Years back RBI introduced the When Issued market and STRIPS, but neither has gained
traction.
Does all this imply that these interest rate products have no use for any participant? Or is it just
that the market, dominated by banks, is not used to availing of risk management options, hoping
instead for regulatory forbearance when episodic yield increase rears its ugly head?
Conclusion
Let me summarize. Market liberalization does not just involve the regulator easing business
processes, introducing new products and creating new markets; it also requires participants to
take initiative to reskill themselves for constantly evolving market conditions and products. Market
development is a two-way interactive process between market participants and regulators. We
are hoping that FIMMDA can rally banks and play its part going forward.
Finally, it is encouraging that FIMMDA is developing the Code of Conduct covering its members'
activities in the interest rate markets. Along with FEDAI's recent adoption of the Global Foreign
Exchange Code, the entire range of bond, currency and related derivative markets would be
subject to professional conduct in line with best international practice, once FIMMDA adopts the
code. I hope that this process can be hastened and FIMMDA members adopt the code signing it
on a public website by the end of the current quarter.
References
1. Viral V. Acharaya, Itamar Drechsler, and Philipp Schnabl (2012), "A tale of two overhangs: the
nexus of financial sector and sovereign credit risks," Financial Stability Review, Banque de
France, April 2012.
2. Viral V. Acharaya, Itamar Drechsler, and Philipp Schnabl (2015), "A Pyrrhic Victory? Bank
bailouts and sovereign credit risk," Journal of Finance, 69(6), 2689-2739.
3. Viral V. Acharaya and Sascha Steffen (2015), "The "greatest" carry trade ever? Understanding
Eurozone bank risks," Journal of Financial Economics, 115, 215-236.
4. Bruegel database of sovereign bond holdings developed in Merler and Pisani-Ferry (2012)
(updated as of March 2017)- Silvia Merler and Jean Pisani-Ferry, "Who's afraid of sovereign
bonds", Bruegel Policy Contribution 2012, February
2012 bruegel.org/publications/datasets/sovereign-bond-holdings/.
1
Government securities are defined under law as both Central Government securities (G-Secs) and State
Development Loans (SDLs). In terms of management of interest rate risk in the investment book, both are
equally important. In this speech, however, data and charts pertain to only G-Secs for simplicity. Inclusion of
SDLs would not change the broad conclusions, and as they contribute to interest-rate risk, would only
strengthen them.
2
There are other reasons for banks to focus more closely on interest rate risk that I haven't touched upon in
interest of simplicity and brevity. For instance, banks face not just the interest rate risk of the investment portfolio
but also to the risk in the banking book. The present guidelines require banks in India to compute change in
economic value of equity (ΔEVE) and net interest income (ΔNII) for the entire balance sheet and not just for the
banking book positions. However, in order to promote global consistency, transparency and comparability of
interest rate risk in the banking book (IRRBB) with that of global banks, banks would be required going forward
to compute IRRBB separately and disclose it based on revised BCBS standards. Similarly, the Report of RBI's
Internal Study Group to Review the Working of the Marginal Cost of Funds based Lending Rate (MCLR)
System has recommended that floating rate loans be referenced to an external benchmark. Once introduced,
this would expose banks to higher market risk, necessitating more active management of interest rate risks.