INTERESTRATE AND BANKING
InterestRate and BankingInterestrates are vitalin how a bank makes money whether in driving securities and depositpricing, loans and borrowing costs or impacting on default rates,loan  demand and capital  markets  activity. Interestrates impact bank earnings through net interest margins and netinterest income.The relative degree of interest rate volatility is directly linked tothe monetary policy of the Reserve Bank. A change in approach fromtargeting interest rate goals towards monetary targets of moneysupply growth increases the interest rate volatility.Nomatter what, interest rate volatility exists and thus, theappropriate measurement of management of interest rate risk isimportant to every bank. The focus on net interest margin or netinterest income is a key factor driving bank earnings and stockperformance as net interest income constitute about 60-65 percent ofbank revenues. The common understanding is that when interest ratesincrease, banks’ net interest margins usually decline, as banks aremore liability sensitive. On the other hand, net interest incomecould improve during a period of rising rates if banks had forecastedand prepared for it (Lewis, 2016). The presence of the additional newloans and assets that price off long-term rates would be at higherrates. As with the case with mostly residential real estate relatedassets and commercial real estate.Thephenomena where bank forecast an increase in interest rate by 85 bps,effective understanding of the various issues could be important inensuring profits for the bank. When there is a rising long-terminterest rates, the bank may reap more. The bank will get a chance todeploy its assets into higher yielding fields that would boost netinterest margins. In the existing condition, 85 bps are estimated toboost the bank in long term rates adding up 15-20bps to net interestmargins for about 3 years or more.Loanyields are derived froma market interest rate which depends on the loan type as well as thetime it will take to mature and risk profile. The bank manager shouldensure that the bank has fixed a loan rates. This will make sure thatits yields would not change over a given period and asthey are mostly based on rates on the treasury yield curve thatcorrelates to the average maturity of the loans. With forecastedincrease in interest rate, the bank would not be supposed to give outfixed interest loans as this may lead to loses. As the bank’sassets contribute the highest amount in the balance sheet worth6800,then it should focus on increasing its liabilities and reducing theequity. Every loan below the 85bps should be terminated. For instancethe interbank lending would yield: 5.05/100* 700 = $35350000 in the market.Onthe other hand, fixed rate mortgages would yield:7.85/100* 1300 = $98540000 in the market.
Ina steady bps, banks earn on deposits as there is low/flat rateenvironment. When interest rates change as in this case, banks needto reprise deposits to reflect market rates. If priced withoutconsidering the right figures, the bank deposit base could shrink andtherefore reducing its ability to make loans andother investments. With the forecast, the bank needs to reprise itsDemand deposits, Savings accounts, 1-year and 5 years CDs andinterbank borrowings. In addition, commercial paper and subordinateddebt and fixed rate should vary depending on banks strategy, assetliability position and deposit base. This will be a reason such thatwhen interest rates start to increase,depositing reprising may increase as customers seekfor higher yielding products as rates increase and commercial depositcustomer reduce their deposits to invest and grow.
Forecastedhigher interest rates can be a positive thing for banks, as theyuplift asset yields, deposit margins as well as improve themacro conditions. The bank can plan for these rates to have apositive yield curve or bank balance sheet. This will help evadeunrealized losses and other accumulated comprehensive income.The bank can equally invest on enough capital that will withstand theexpected rise in rates (Jones and Kulish, 2013). Theimpact would then be positive as the bank will use its grownsecurities balances at a faster pace than loans over the time whenthe rise in bps would stand. Other informationthat may be incorporated by the bank in analysingare changes in market share,market perceptions via share price,changes in key managementand impact of macroeconomic changes.
Thebank should not be tempted by the relatively steep yield curve toplay the carry trade where it invests in longer dated mortgageloans or assets. Instead it should also reduce its reliance onwholesale funding by running off long-term debt. This is because theyhave declined income as a percent of total assets. It should shiftaway from wholesale funding and instead invest on deposit fundingwhich is a positive when rates are low and when high (Patel, 2012).If the bank is market sensitive, it should increase its net positionon treasury and mortgage backed securities for some time. Incase of higher long rates, the reduction in the value of the existingholdings would not negatively affect capital.
Thenet effect of interest rate changes bank revenue and costs. Anincrease in bps would automatically increase bank costs and revenueswhich will determine its profits. However, all these would depend onaverage maturity of the bank’s assets and liabilities.
Thecurrent ratio is equal to: 6800/ 5900 = 1.15254
Onthe other hand, debt to total asset ratio is 5900/6800 = 0.86765
Theexisting balanced bank asset and liability leaves profit streamunaffected by increased interest rate. Such case would need the bankto borrow on short term and lend on long term so that their averagematurity assets exceed the average maturity of their liabilities.
Jones,C. and Kulish, M. (2013). Long-term interest rates, risk premia andunconventional monetary policy. Journalof Economic Dynamics and Control,37(12), pp.2547-2561.
Lewis,M. (2016). Financialintermediaries.Northhampton, Mass.: Edward Elgar Pub.
Patel,C. (2012). A Convenient Scapegoat: Fair Value Accounting byCommercial Banks during the Financial Crisis. CFADigest,42(3), pp.80-82.